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At what point does junk start to look like diamonds in the rough?

There's no clear answer, but it's a topical question whenever a financial squall blows through the capital markets and risk is repriced. It's clear that we've suffered a storm of late, but it's debatable if risk has been repriced on a dramatic scale.

Risk, for purposes of this post, is defined as the spread in high yield bonds over 10-year Treasuries. By that measure, junk commands a premium of 4.37% over the 10-year as of Friday's close, as per Citigroup High Yield Index (NYSE:C))over Treasuries. The 4%-plus is significantly higher than the 2.6% spread offered by Mr. Market at the end of June, as our chart below shows. But while the rise looks impressive in the context of recent history, it's still debatable as to whether it also looks compelling enough to commit fresh capital to the asset class.

Deciding if junk's spread now looks rich enough to compensate for risk depends on one's confidence in the future. For those who believe that the economy will continue growing at a healthy if not necessarily exciting pace well into next year, the prospect of earning 400-plus basis points over Treasuries may entice. Indeed, the current spread is the highest in more than two years. And 400 basis points of additional yield is nothing to sneeze at when compounded over, say, a decade.

But for those who worry that the economy is vulnerable to the real estate fallout, the current premium in junk doesn't suffice, i.e., the threat of capital losses in junk still looks poised to overwhelm any extra yield. There are two ways to change that. One, the economic forecast turns brighter. Two, the spread runs higher.

In fact, the spread's been higher - much higher in recent years, as our chart illustrates. No, we're not waiting for a return to the extreme levels that prevailed in 2002 and 2003. But current levels are not yet a no-brainer buy either.

If GDP's growth slows by more than a little, or certainly if it contracts, worries about less-than-investment-grade bonds will surely suffer. All the more so given the recent anxieties of late over securities with less-than-stellar credit ratings.

In fact, one can argue that investors generally remain cautious when it comes to high yield bonds. Morningstar's (NASDAQ:MORN))high yield fund category posted a 0.6% loss for the four weeks through Friday. Meanwhile, intermediate government bond funds gained 0.7% over the same period and long government bond funds jumped 2.6%.

The preference for quality is clear. Of course, the past always is clear. Deciding if the storm has blown over or not is the question. We're as clueless about the future as always. Making a bet that all's well has its place, of course, and for some this may be the moment to act. But our guarded brand of contrarian-minded nibbling doesn't yet find the junk menu sufficiently tasty. That's not necessarily indicative of the prospective opportunity in the asset class, but it's our view and we're sticking with it, at least for the moment.

Your editor, in short, has an affinity for letting others lead the charge into risk at moments of higher-than-normal uncertainty. That philosophy necessarily precludes big gains born of rushing in ahead of the crowd. It also keeps us whole when opportunities are less than they appear.

Nonetheless, we're watching and waiting. Market sentiment has clearly changed. So too have the valuations. But what of the economic outlook? Has that changed? And if so, for the better or worse? We'll never know for sure, but we'll need another notch or two of confidence before we make a decision.

As such, we're not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets. What's more, we're reluctant to state a particular number for when the spread will entice for the simple reason that context is everything. One spread number may look juicy, but the economic tailwind must be sufficiently encouraging too. Yes, we may be wrong. If so, it wouldn't be the first time. But sometimes being comfortable takes precedence.

Source: Assessing Risk: When Does a Yield Become "High?"