Prepare For The Possibility Of Much Higher Bond Spreads

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 |  Includes: HYG, HYLD, JNK, PHB, TLT
by: The Financial Lexicon

Over the past month, high-yield corporate bond spreads have quietly risen 60 basis points off their 2012 low of 524 basis points. The following table shows the spread over Treasuries of the "BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread" since the October 18, 2012 low.

 

High-Yield Spread

(basis points)

10/18

524

10/19

531

10/22

528

10/23

541

10/24

539

10/25

533

10/26

541

10/29

546

10/31

563

11/1

557

11/2

554

11/5

557

11/6

549

11/7

563

11/8

567

11/9

577

11/12

577

11/13

582

11/14

584

Click to enlarge

During the same time period, the yields on the 5-, 10-, and 30-year Treasuries (NYSEARCA:TLT) fell 15.8, 23.7, and 27.9 basis points respectively. In general, this implies lower prices for high-yield corporate bonds, as spread widening, on a market-wide basis, outpaced the benefit from falling benchmark yields. Not surprisingly, given the fact that spread widening has outpaced falling benchmark yields, each of the four high-yield corporate bond ETFs I like to follow have declined in price. These four are the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG), the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK), the Invesco PowerShares Fundamental High Yield Corporate Bond Portfolio (NYSEARCA:PHB), and the AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD).

High-yield debt has been a part of the financial markets investors have recently favored as a way of finding yield. Given the number of new investors flocking to high-yield debt in recent months/years, there are likely many people who have never experienced what it feels like to go through a spread widening period in corporate bonds. If nothing of consequence is accomplished regarding the fiscal cliff, not only will we likely see a much lower S&P 500 in the coming months, but corporate bond spreads, especially high-yield bond spreads, are likely to widen significantly. I'd like to help some of the newer high-yield bond investors by providing the following table, which shows the level to which spreads rose during several "risk-off" periods in financial assets.

 

High-Yield Spread

(basis points)

6/5/12

723

11/24/11

803

10/4/11

910

5/25/10

724

2/12/10

702

12/15/08

2,182

10/10/02

1,120

Click to enlarge

Again, today, even after the recent 60 basis points rise, the high-yield corporate bond market spread to Treasuries is only at 584 basis points. While 584 basis points does represent an average amount of value from a spread perspective (don't confuse yields with spreads), it is nowhere near a level investors should consider significant value given some of the risks immediately facing the U.S. economy. If there is no market-pleasing solution to the fiscal cliff and/or a mild recession in the coming months, you should expect high-yield spreads to quickly jump above 700 basis points and likely go to 900 basis points. The same is true if the Israel-Hamas situation in the Middle East escalates further or if there is another episode of bond market woes in Italy or Spain.

In addition to the fact that spreads will go much higher if any of the aforementioned situations occur, it is important to illustrate just how quickly corporate bond spreads can move. One example comes from the 2011 time period surrounding the debt ceiling debate.

 

High-Yield Spread

(basis points)

7/27/11

532

7/28/11

537

7/29/11

551

7/31/11

558

8/1/11

563

8/2/11

580

8/3/11

587

8/4/11

616

8/5/11

624

8/8/11

684

8/9/11

719

8/10/11

730

8/11/11

739

Click to enlarge

In just 12 trading days, the "BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread" jumped 207 basis points. During the same time period, the 5-year Treasury note fell just 53.3 basis points. This implies a significant rise in yields (lower prices) for high-yield bonds over just a 12-day period, which is exactly what happened during that time. Rather than sift through trading data on individual bonds, investors can verify the lower prices for the high-yield corporate bond market by looking at charts of the aforementioned ETFs, HYG, JNK, PHB, and HYLD. During the spread widening of July and August 2011, each of those ETFs experienced a strong pullback.

Given how quickly corporate bond spreads can widen, now is the time to prepare for the possibility of much higher spreads in the weeks or months to come. For individual bond investors, create your list of bonds you would like to purchase on a big pullback right now, and monitor those bonds like a hawk. In the world of individual high-yield corporates, the best quality bonds sometimes offer only small windows of opportunity to purchase them at cheap prices. This is especially true for individual bonds that are less actively traded.

For investors who gain exposure to high-yield corporates through ETFs, be sure to follow not only high-yield corporate bond spreads, but also whether the ETF you are interested in purchasing is trading at a discount to net asset value (NAV). Often times during market-wide sell-offs in high-yield debt, corresponding ETFs will trade at discounts to their net asset values. You can find out if the ETF you are following is trading at a discount to net asset value by going to the ETF's webpage and comparing the recent NAV to the recent share price.

Disclosure: I am long HYG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.