Q & A: When does “High Yield” get expensive?

February
11

Written by: Jon McGraw

One question we’ve heard a few times expressed by both the media and investors is: when does high yield get expensive?

We typically measure bond valuations in terms of yields compared to inflation and ‘spreads’ of one asset class to another. Generally, high yield bonds have a different experience than more conventional investment-grade bonds. While many forms of investment-grade debt tend to remain in somewhat of a tight range compared to Treasuries (2008 dislocations aside) with periods of ‘average’ spreads lasting for some time, high yield spreads have been less prone to stay at average for such long periods, and gravitate towards ‘expensive’ and ‘cheap’ based on macro, fundamental and technical conditions.

Currently, we’ve just moved a little more expensive than ‘average’ (4.8% spread compared to an average of 5.5% and all-time low of 2.3% over Treasuries) but don’t appear to be in the danger zone. Often, as with equities and other risk assets, the progression can be laid out in a series of steps, similar to innings in a baseball game, where early buyers (where we target) moved in during the early innings when valuation was extremely compelling; then, the middle innings demonstrate continued potential for spread compression and high yields, which add to performance numbers; and, lastly, the latter innings, where spreads become more compressed, may not compress a lot further, and the last investors jump on the bandwagon after seeing a few years of exceptional returns being advertised.

Any asset ceases being attractive to us when the potential risk begins to outweigh the potential expected return. Currently, positives continue to be apparent: strong underlying credit conditions with improved debt ratios and lower default rates. The larger coupon causes such bonds to be less sensitive to interest rate increases, so there is some built-in protection here. For the time being, even if rates and general conditions remain as they are, a 7% yield return is quite attractive.

While we’re on that note, how about the broader picture currently? Much like in the analysis of our political environment, we seem to have two camps of prognosticators developing—long-term bullish versus the perpetual bears. On the short-term side, we’ve had a strong run so far this year, so a few percent downward wouldn’t be out of the question. We are more focused on the longer-term trend and sentiment.

Positives:

  • Valuations are supportive of risk assets (stocks are 10-20% undervalued in the U.S. and a bit more so in Europe and EM).
  • Sentiment in risk assets remains poor compared to historical levels. Cash flows, which had been heavily moving toward bonds, have just started to turn positive for stocks, but the magnitude is small and there is a lot of ground to make up for the huge flows into fixed income in recent years. The large amount of cash on the sidelines and bonds assets could provide a catalyst for equities as the recovery solidifies (and rates move up—reminding bondholders of the risk here).
  • There appear to be fewer shorter-term ‘tail risk’ events on the horizon, now that the fiscal cliff has been pushed off and European solidarity has been tightened, but they are still out there. These are more ‘conditions’ than immediate ‘crises,’ especially in the European case.

Negatives:

  • Economic growth overall, both in the U.S. and globally, is still very slow and could be subject to negative surprises and some lulls.
  • In addition, the fiscal cliff and European issues are still out there, and could provide news-driven volatility as elections and other key decisions are speculated about. Markets like certainty, and, even more so, hate uncertainty, and will retreat in the face of it (for a while).
  • Of course, monetary stimulus raises the long-term risk of inflation. Owning variable-rate debt, commodities, real estate and even equities can help provide an effect hedge against this impact.