High Yield Bonds and REITs: A Spread Analysis

Repricing of risk is, in theory, a fertile time for minting new opportunities for strategic-minded investors. But, of course, there's a catch: the financial gods always forget to send instructions for making sense of the upheaval. That leaves mere mortals with the task of sifting through the data in the hope of finding order amid the chaos.

With that prelude, we present the widening spreads in two asset classes that have caught our eye in recent weeks: high yield bonds and REITs. Both have fallen on hard times of late, and so it comes as no shock to learn that their respective trailing yields over the 10-year Treasury's counterpart looks compelling, relative to recent history.

Consider the chart below, which shows that spreads in junk bonds (represented here by monthly data for the Citigroup High Yield Index through the end of last month) have risen to the highest level since mid-2003. REIT spreads have improved too, but less so. Nontheless, FTSE NAREIT Equity REIT Index's (REZ) spread over the 10-year has climbed to its highest mark since the spring of 2004.

Of course, higher spreads by themselves are no guarantee of easy profits from here on out. Indeed, Mr. Market never reveals his game in advance and so all the usual caveats apply when reading the past in the hope of divining the future. Nonetheless, we're a believer in the proposition that lower prices equate with higher prospective returns. The trick is deciding when prices are at or near the end of their descent, at which point expected returns are at their highest. No one really knows, of course, at least not in real time, which suggests that diversifying one's opportunistic buying efforts over time and over different asset classes is still the best game in town.

And while we're pointing out caveats, let's point out too that Tuesday's higher spreads enjoy that label only because the previous spreads were extraordinarily low by historical standards, as the above chart reminds. Taking in a longer-term perspective shows that what looks like juicy spreads by the standards of the past 12 months are merely middling, if that, when measured against the record of the past decade.

Finally, investors should keep in mind that a fair amount of the recent upturn in spreads is due to the forceful downturn in the 10-year's yield. Consider our second chart below, which shows the Treasury yield taking a fresh dip.

click to enlarge

For the moment, the diverse trends bring opportunity in the form of higher risk premia, although that's no assurance that tomorrow won't bring an even better deal. Nonetheless, we'll keep watching and nibbling.

Comments

[jack kreg]

I like the analysis, still looks like REIT's yield's are pretty low and Junk bonds have a ways to go to reach their previous highs of 8 or 9 %, from the last recession.
Also, more compelling is the spread between, investment grade corporates, like the bond ETF, iShares Lehman Aggregate Bond, symbol AGG, and the 10 year treasury. While the yields on the 10 year have plunged to 3 3/4%, investment grade corporates are at still near 5%. I am selling some of my long term government bonds to buy the AGG, ETF, it is diversified and has a low cost fee, 0.25%.