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High Yield Bonds Near Fair Value

|Includes:iShares iBoxx $ High Yield Corporate Bond ETF (HYG), JNK

With OAS at 595 for the Barclays US High Yield Index we may have reached yet another inflection point with regards to the high yield space. On average bonds are trading 2-points over par and have a YTM of 6.89%.

Trailing 12-month default rates were 3.12% by end of July 2012. As we know, markets are forward looking and spreads will factor future default rate expectations plus some liquidity premium which has averaged around 325bps historically. Hence, the market is implying a default rate of 3.85% over the next 12-months currently. This would be a tick up from current levels and would not be out of the realm given some recent macro deterioration in growth expectations.

Given this backdrop, high yield bond investors may be content with clipping coupons from this point forward as capital appreciation may be limited. Further appreciation would depend on whether or not the "hunger for yield trade" trumps fundamentals and squeezes the liquidity premium lower - quite possible as 6.9% yields may continue to attract capital regardless of underlying fundamental change so long as risk is compensated for.

If one is overweight the high yield bond space, now may be a good time to start paring down exposure and get closer to a market weight for relative return oriented portfolios. The nominal yield level still has merit for more absolute return oriented strategies albeit sizing will require active monitoring and occasional risk management techniques may have to be applied as well as portfolio interaction consideration.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Stocks: HYG, JNK