With monetary accommodation from the Federal Reserve now always prefaced with the word "extraordinary," it is not surprising that we are seeing new records throughout the fixed income universe. The speculative grade bond market set a new record last week with the yield-to-worst on the Barclays Capital High Yield Index yielding below five percent for the first time. With yields at new record lows, the index also hit a new record high dollar price of $107.36.
During the depths of the credit crisis, the yield on the aforementioned index reached a record high of over 22%. Just four years later, the yield on the index has went from its all-time high to its all-time low. Today's index yield is less than the Federal Funds rate of 5.25% pre-crisis. In 2006, you could have made a higher yield on an FDIC-insured savings account than by lending to highly levered corporations in 2013.
So should holders of speculative grade bonds sell with prices at all-time highs? The credit spread on corporate bonds is compensation for expected future defaults. When markets were trading at record high yields in early 2009, expected default rates were in the double digits given a looming maturity wall, the expected inability of banks to roll bank debt financing given their own capital and liquidity constraints, and plummeting economic growth broadly crimping results across a host of industries. Today, expected defaults remain low given continued monetary accommodation and recovering economic growth. Corporations have been able to refinance debt, lowering interest expense and extending their maturity profile, which in turn has lowered credit spreads and further contributed to reducing debt costs in a virtuous cycle for levered companies.
While yields on speculative grade bonds are at record lows, credit spreads are still well above their historical trough reached in 2007. Bond yields have two components: the reference matched duration Treasury yield and the credit spread above this rate. The impact of historically low Treasury yields has forced down corporate bond yields, but the current average spread of 418bps appears to still be appropriate compensation for expected defaults. Below is a graph from Barclays Capital that compares junk bond credit spreads and trailing realized defaults historically.
Source: Barclays Capital, Moody's
It appears that there is still some incremental room for credit spreads to tighten, and given the recent acceleration of spread compression these gains could come soon. Any near-term back-up in rates is likely to be absorbed in the credit spread, meaning spreads would tighten sufficiently to offset the higher rate component to leave bond prices unchanged. With junk bond yields at all-time lows, I offer several suggestions for Seeking Alpha readers:
- I would rather own higher quality double-BB rated bonds than reach down into low single-B or triple-CCC rated bonds whose credit spreads may not be sufficient for higher expected future defaults. Double-BB rated bonds always provide incremental spread for their realized defaults, and over long-time intervals have produced realized returns surpassing lower rated cohorts due to their lower realized default rates. (See: "The High Yield Bond Trade for the Long Run"). If yields on BB-rated bonds do not meet your return requirement, then I would rather add a modest amount of investment leverage through your broker than go down the credit curve.
- High yield bonds are going to be more rate sensitive than at any time in the history of the asset class. While expected defaults are likely to remain low as monetary accommodation continues to push investors out the yield curve, default rates will eventually rise. Some speculative grade issuers, emboldened by the availability of cheap financing, will construct capital structures that are ultimately unsustainable. Credit spreads are in part a function of the business cycle, rising in times of economic contraction. When untenable capital structures and declining economic growth meet, defaults will rise, and given the high yield market's record duration, bond prices could fall materially. I would rather lever short duration bonds where the bond financing takeout appears more visible amidst the backdrop of Fed support, then own higher yielding, more volatile longer duration credits. Short duration high yield bond funds include: SPDR Barclays Capital Short Term High Yield Bond (SJNK), PIMCO 0-5 Year High Yield Corporate Bond ETF (HYS), and Wells Fargo Advantage Short-Term High Yield Bond (STHBX). I caution that as yields have fallen, expense ratios as a percentage of all-in yield have risen, so if you can build a diversified bond portfolio without using funds, you could be better off.
- While I believe that double-BB rated bonds will offer superior risk-adjusted returns over the long-run, triple-CCC rated bonds have produced higher total returns in each month of 2013 as credit spreads have tightened the most for the most speculative credits. Understanding the alpha-generative momentum effect in corporate credit spreads can help investors understand how to toggle between higher quality BB's and higher yielding CCC's.
- With near zero interest rates in savings accounts, some retail investors are discovering the high yield bond market for the first time. The largest ETFs - the SPDR Barclays High Yield Bond ETF (JNK) and the iShares iBoxx High Yield Corporate Bond ETF (HYG) have seen tremendous growth. Given that high yield bonds are traditionally a less liquid asset class and exchange traded funds demand instant liquidity, these funds typically buy larger and more liquid bond deals. This has moderately distorted pricing in the bond market with smaller deals trading at a meaningfully large spread differential (>100bps), providing investors who can do their research and source these smaller deals the opportunity to glean excess spread.
- Some fixed income investors should consider low volatility equities (SPLV) as an alternative to high yield bonds. Given the rally of high yield bonds to new record high prices, trailing returns are impressive, but they still have not outperformed low volatility equities historically despite their higher variability of returns.
High yield bonds are going to return on average five percent to their call date or maturity exclusive of realized defaults. With a dividend yield of 2.7%, perhaps income investors should favor low volatility equities as an alternative to high yield bonds where prices are capped by calls and investors are forced to pay a premium above par for a traditionally speculative asset class. At a current P/E of 20, low volatility equities are producing an earnings yield of 5%, equivalent to the yield on below investment grade bonds. Adding in a modest level of earnings growth, low volatility equities could outperform high yield bonds from a total return perspective with lower volatility.
Records are made to be broken, but the new all-time low yields for speculative grade credit are painful for income-oriented investors. I hope this discussion of the relative value of the high yield market, and my tips on positioning your bond portfolio can drive further discussion on this asset class.