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In September, most of the world’s major central banks doubled down on their bets to suppress long-term rates. With yields close to historic lows and, in many cases, below the level of inflation, many investors responded by turning to high yield. Indeed, I have argued that in this environment, fixed income investors have no choice but to either accept lower income or more risk and given that, investors should consider focusing on credit risk rather than duration. I still believe that marginal credit risk makes sense, particularly for aggressive yield-hungry investors, but the recent rally in high yield suggests that downside risks may be starting to outweigh the potential benefits.

Since the spring, the spread between the Barclays High Yield Index and the 10-Year Treasury note has narrowed from 608 basis points at the end of May to 475 basis points today:

(click image to enlarge)

The rush into high yield and the contraction in spreads is understandable. In a “low-for-long” environment, yield hungry, fixed-income investors have few other alternatives. In addition, many investors who would typically have a higher equity allocation have opted for “equity light” exposure through high yield. That said, the recent rally in fixed-income has pushed spreads well below their long-term average – 535 basis points – and to their lowest level since July 2011.

In one sense, tighter spreads are justified. U.S. corporate balance sheets look pristine, with S&P 500 companies sitting on more than $2 trillion in cash. That’s equivalent to more than 7% of their market cap, the highest ratio since the early 1960s. As a result, default rates are only around 2%, which is half of their long-term average.

Yet investors still need to be cautious. Spreads at this level appear rich not only relative to their historical average, but also particularly in the context of our current sub-par growth. High yield is the most economically sensitive of all the fixed-income segments. With economic growth stuck in the 2% vicinity, spreads would typically be closer to 600 basis points over Treasuries, as opposed to the current level of under 500 basis points.

And this all assumes the U.S. is able to avoid the fiscal cliff and a recession 2013. While investors are starting to factor the fiscal cliff into their equity decisions, it is not clear that they are doing the same for the fixed income portion of their portfolios. If a trip over the fiscal cliff puts the United States back into a recession, then high yield would likely disproportionately suffer compared with other fixed income asset classes.

This is not to say that further spread tightening is impossible. Improving conditions in Europe, a favorable resolution to the U.S. fiscal cliff (along with a willingness to address longer-term structural budget issues), and a steadily improving economy could all help to lower risk premiums, bolster corporate credit profiles and allow for further spread tightening. In fact, spreads have been considerably tighter in both the mid-1990s and the mid-2000s. But those environments were characterized by much faster growth and less systemic risk. The problem today is that it seems unlikely we will return to those conditions anytime soon.

Longer term, I still like high yield as an efficient way to generate potential yield with a reasonable amount of volatility. In addition, for more aggressive yield-focused investors – which we’ll define as those with a target yield of 4% to 5% – there are simply few alternatives. For the rest, and particularly for more tactically minded investors, this is probably an opportune time to reexamine your high yield exposure.

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Source: High Yield Is Looking Expensive