In The Hunt For High Yield, Proceed With Caution

| About: iShares iBoxx (HYG)

Given high yield credit’s recent rally and surge of inflows, I’m now getting a lot of questions about whether or not the asset class still looks appealing.

While high yield provides an attractive pickup in yield and I’m maintaining my neutral view of the sector, I believe the easy money has probably already been made and the asset class no longer looks cheap. As such, over high yield, I prefer investment grade credit and municipals.

As high yield credit is highly correlated with equities, it’s hardly surprising that the asset class has rallied sharply since fall lows, taking part in the strong rebound in stocks and other risky assets. The iShares iBoxx $ High Yield Corporate Bond Fund (NYSE ARCA: HYG) is up more than 12% from its early October closing low. And of course, this surge in price has been accompanied by a surge in flows. Year to date, $6.5 billion has flowed into high yield exchange traded funds, with half going to HYG.

Following this rally, the yield to maturity for high yield is roughly 7% or nearly a 500 basis point premium to the 10-year Treasury. That’s close to fair value given the following analysis.

When you look at the historical spread between high yield and the 10 year-Treasury, spreads typically tighten as expectations for the economy improve. They widen when investors are worried about a recession and credit quality. In the past, economic indicators have explained roughly 50% of the variation in where high yield spreads relative to Treasuries, testifying that the economic situation has been a key driver of spreads historically.

A comparison of high yield spreads with leading indicators today suggests that high yield should be yielding roughly 500 bps more than the yield on the 10-year Treasury, fairly close to current levels.

To be sure, I don’t believe investors should avoid high yield. Investors in high yield are still picking up significant incremental yield, and given strong corporate balance sheets, I don’t expect any significant pickup in default rates. But as the asset class no longer appears as inexpensive as it was last fall, I wouldn’t advocate aggressively putting new money to work in high yield.

Instead, I prefer investment grade and high quality municipals. I hold overweight views of both asset classes, which still appear relatively cheap versus Treasuries. Take investment grade credit, which is a nice substitute for those looking to lower their exposure to Treasuries. While high yield spreads have contracted by 250 bps since last fall, spreads for investment grade credit have not come in nearly as much.

Investors can access investment grade credit through the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE ARCA: LQD) and they can access municipals through the iShares S&P Short Term National AMT-Free Municipal Bond Fund (NYSE ARCA: SUB) and the iShares S&P National AMT-Free Municipal Bond Fund (NYSE ARCA: MUB).

Source: Bloomberg

Disclosure: The author is long LQD and MUB

Disclaimer: The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted.

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