Silver Linings: Allure and Risk

Financial crises, bank implosions and chaos generally don't often inspire. But every debacle has a silver lining. One of those linings shows up these days in higher interest rate spreads. Investors willing to wade into the riskier realms of debt are being paid for their troubles, or so one could argue.

As our chart below shows, you get more for your money these days when buying high-yield bonds and Baa-rated corporates, the lowest tier of investment grade debt.

High-yield bonds (as per Citigroup High Yield Index) offered an 875-basis-point yield premium over a 10-year Treasury Note as of Monday's close. Meanwhile, the yield on Baa bonds (represented by Moody's Seasoned Baa Corporate Bond Index) closed at 378 basis points over the 10-year the same day. As the graph above relates, those are the highest risk premia in roughly six years.

But are they high enough? Do they fully compensate for the turbulence ahead? Since we don't really know what degree or type of hazards await, we must remain agnostic when it comes to proclaiming definitive answers. Common sense, however, suggests that there's still trouble afoot, and so one can't be fully confident that the elevated risk premia noted above will suffice. But they might.

The potential for capital losses that exceed the received yield is an ever-present risk, and perhaps more so than usual in the early days of autumn in these United States. At the same time, it's getting harder to ignore the rising spreads. It may be too early to make hefty bets about the future, but it's not too early to begin dipping one's investment toes into the riskier ranks of bonds. That's especially true for those with an existing multi-asset class portfolio, a long-term perspective and an underweight position in lower-grade fixed-income allocations.

There are no guarantees with investing, but you can count on variations in risk premia. Ignoring the variations is imprudent, but so is diving in head first at the first uptick in yields. Finding a middle ground is the goal, and arguably that middle terrain begins with a toe in the water now.

Yes, spreads may be higher down the road. Or not. We don't know, and neither does any one else. You can bet the farm one way or the other. Alternatively, you could make modest buys on occasion, when the odds seem at least moderately favorable. Might these be one of those times?

Comments

[Chris B:]

Based on these numbers, perhaps the govt. is charging too low an interest rate to AIG et. al.

I'd like to see a longer term chart.

2008 Sep 24 12:28 PM

[JasonC:]

Remember, those are the amounts *above* what a treasury bond of the same maturity, is yielding. With 10 years at 3.75% or so, a 4% spread means 10 year debt is available at 7.75%.

As for what future credit losses will be, the past is some guide though not a perfect one. You can simulate the losses on bonds of a given rating using the downgrade and default chances per year Moody's publishes. BBB rated can have credit losses in the 0.5 to 1% a year range, but not in the 4% a year range. Meanwhile As can be bought today for spreads not much less than that, with 0.5% historical credit losses, or less.

In the unfavored sectors it gets even more extreme. Real estate names, add a percent. Banks, add a percent. Regional banks smaller than the top tier, add another percent or two. A rated regionals are trading like single B junk, as though a third will default within 5 years. And unless the banking system collapses, that's nuts.

5 years from now this crisis will be a memory, and spreads will be normal. A few companies will have blown up in the meantime, to be sure. But these spreads cover a multitude of such problems, as will appreciate from spread contraction on all the bonds still paying, when things return to normal.

2008 Sep 24 01:01 PM

[Inzight:]

Commodities are no-brainer in times like this

Copper/gold daily news, followup and the miner TSX-v stories - all in layman's terms

mining101.blogspot.com

2008 Sep 24 01:34 PM

[nym:]

Nowhere here do I see any mention of inflation/devaluation. I don't see any headroom in these rates.

2008 Sep 24 02:01 PM

[buyitcheap:]

the author is right - these bonds aren't cheap enough yet...

2008 Sep 24 03:05 PM