With all the talk of a bond bubble permeating the investing world, it might be tempting for some investors to turn a blind eye to all bonds. However, there is at least one area of fixed income that currently has value and should be on your radar screen: High-yield bonds.
How can this be? After all, as the chart below clearly shows, effective yields across the high-yield market are near decade and a half lows. While this is true, focusing on effective yields is just one piece of the puzzle. Spreads is another piece; it is the piece that is currently sending the message that there is value to be found in high-yield bonds.
As I mentioned in a recent article, high-yield spreads to Treasuries, as measured by the "BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread," recently reached a new high for 2012, now at 7.17%, up 123 basis points in the past month alone. How does this spread compare to historical levels? Let's start by taking a look at the highest levels this spread reached dating back to 1997 (the beginning of the spread's existence).
BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread
As you can see, since 1997, during years in which the macro environment and financial conditions were generally calm, spreads never reached the levels they are at today. In fact, in 1997, 1998, 2005, 2006, and 2007, the high-yield spread dropped to under 3%, more than 400 basis points lower than where we are today. For investors who are less comfortable comparing today's spread to anything pre-2008 financial crisis, let's take a look at 2011, the year in which spreads finally found a bottom from the long decline that began on 12/15/2008 at 21.82%. In 2011, the high-yield spread was able to spend a significant amount of time hovering in the 4.50% to 5% region, more than 200 basis points lower than we are today. If you believe the post-2008 financial crisis world will look different than it did before 2008, then look to 2011 for an indication as to how low spreads can go in this era of perpetual uncertainty. Perhaps we won't return to a sub-3% spread, but from a valuation standpoint, I'm comfortable with the assumption that we can return, at some point, to at least a 5% spread. And a 5% spread is 2.17% lower than today's level.
Therefore, if you purchase high-yield at today's 7.17% spread and benchmark interest rates rise because of an improving macro economic situation, you will likely have an embedded hedge in your position of approximately 2.17% or greater. The embedded hedge is the declining corporate bond spreads that historically have occurred when the macro environment and financial conditions improve. In other words, if Treasury yields rise due to an improving economic scenario, high-yield spreads should narrow, offsetting to some extent the unrealized mark-to-market losses we hear about all too often (don't forget that individual bonds mature at par). Furthermore, during that time, you will continue to collect attractive coupons.
What about if benchmark Treasury yields drastically rise due to the bond vigilantes finally rolling into town and going after U.S. government debt? Under that scenario, I think it's a bit difficult to predict how corporate bond spreads would react. I can make a case for spreads, both investment grade and non-investment grade, going wider or coming in. That would be a unique situation that would have to be addressed at the time. For the time being, if a revolt against Treasuries is a concern of yours, you could consider pairing an investment in high-yield bonds with gold or pairing it with longer-term, deep out-of-the-money puts on a Treasury-focused exchange traded fund such as TLT.
Now, just because an investment has value at current prices doesn't mean it can't have even more value in the future. During the 2000 to 2002 bear market, the high-yield spread widened to low double digits. In 2011, when investors were concerned about the possibility of a recession, the spread widened to 9.10%. Of course, during the financial crisis of 2008, the spread reached the incredible level of 21.82% before falling all the way back down to 4.52% on February 21, 2011. At a current spread of 7.17%, there is value in high-yield, but investors should also understand that spreads can go higher. For this reason, it is prudent to use the same approach you might be familiar with when it comes to investing in stocks: buy the dip and average into a position over time.
With some individual stocks or even some indices (think Nikkei and Nasdaq), prices don't always return to levels they once reached (at least not for many, many years). Under that scenario, it can be dangerous to buy the dip or average into a position. When it comes to high-yield corporate bonds, there has yet to be a time when the spread on a market-wide basis widened to levels it is at today and didn't eventually trade narrower. Perhaps this time will be different, but until proven otherwise, I'll take the chance. If you begin to average into a position beginning at today's spread, make sure to leave enough fire power to pick up some high-yield should the spread make it to double-digit levels.
In terms of how to get your exposure to high-yield corporate bonds, there are a number of high-yield ETFs that are easy to find through a simple search on the web. HYG and JNK are two of the more popular and well-known high-yield corporate bond ETFs, but there are others as well. If you are interested in the possibility of investing in individual bonds but are nervous about picking the wrong company, perhaps dipping your toe in the water with some of the higher rated "junk" bonds is the way to start. Below are the details for two such bonds. The first is for a Ball Corp. (BLL) bond that trades like it has a lower investment grade rating instead of a "junk" rating. And the second is a part non-investment grade, part investment grade rated Weyerhaeuser (WY) bond. Although the Weyerhaeuser bond is trading well over par, investors who often shy away from bonds trading at a premium to par due to concerns about call features might be comforted by the fact that it is non-callable.
Ball Corp.'s senior unsecured note (CUSIP: 058498AR7) maturing 3/15/2022 has a 5.00% coupon and is asking 101.75 cents on the dollar (4.773% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note Ba1; S&P rates it BB+.
Weyerhaeuser's senior unsecured debenture (CUSIP: 962166AW4) maturing 10/1/2027 has a coupon of 6.95% and is asking 106.976 cents on the dollar (6.235% yield-to-maturity before commissions). It is non-callable and pays interest semi-annually. Moody's currently rates the note Ba1; S&P rates it BBB- (investment grade rating).
Don't let a belief that Treasury yields might rise over time prevent you from considering corporate bonds. At the moment, high-yield bonds, as a collective whole, actually have higher yields than they did during parts of 2006 and 2007 when the Fed Funds Rate was at 5.25% and intermediate to long-term Treasuries were trading multiple percentage points higher than they are today. That is worth repeating.
High-yield bonds are currently yielding more than they did in 2006 and 2007 when the Fed Funds Rate was more than 500 basis points higher than it is today and when benchmark Treasury yields were at levels multiple percentage points higher than today's yields. This is because at that time, the macro environment was perceived to be good and spreads were narrow. While yields are perhaps the easiest thing for investors to follow, spreads matter, and spreads are a major factor in deciding whether there is value in certain parts of the bond market or not. At this time, high-yield bonds have value, and investors for whom high-yield fits into their investment profiles should consider scaling into a position beginning at these levels.
Disclosure: I am long HYG.
Additional disclosure: I am long CUSIP 058498AR7.