The spreads between the 10-year US Treasury (NYSEARCA:IEF) and that of lower-rate credit are at fairly narrow spreads historically. With the market in "greed" mode and various credit metrics worsening at the household, corporate, and government level, there will come a point where these spreads will fall more in line with historic norms.
The spread between BBB corporate credit yields and the 10-year Treasury yields spends about 80% of its time between 100-300 bps.
During "good times," when credit risk in an economy is perceived to be low, the spread falls below the 100-bp mark. Back in January 2004, this spread fell all the way down to around 60 bps and didn't move beyond 100 bps until March 2005. During "bad times," when credit risk is perceived to be high, the spread can greatly increase beyond the 300-bp mark, as it did from August 2008 to August 2009, reaching a peak of 7.47% in December 2008.
(Source: BofA Merrill Lynch)
This is very much a "reversion to the mean" idea. Given that US Treasuries are about the closest thing possible to a risk-free investment, the spread between BBB credit and that of the 10-year Treasury should always maintain a sensible spread. The BBB rating distinction (used by credit agencies Fitch and S&P) is used to denote debt that resides on the lower end of the investment-grade spectrum.
When the spread becomes low enough, it's essentially the equivalent to betting on higher volatility/lowered perceptions of credit risk in the future. Based on the past twenty years of data we have, the spread is below 100 bps 15%-16% of the time. The spread will always be reasonably positive to a degree, so it's a trade that one could expect to have some sort of floor to it, such that the risk/reward profile can be skewed well in one's favor.
At this point, the spread between the BofA Merrill Lynch US Corporate BBB Effective Yield (the official benchmark used) and the 10-year Treasury is 129 bps. Given the default probability on BBB-rated credit over time is materially higher than the default rate on the 10-year Treasury (largely considered the safest debt in the world), the spread in long-run equilibrium should be around 180 bps.
#1: Lower Risk
Betting on a divergence between a basket of BBB bonds and the 10-year Treasury would entail selling BBB credit and buying the 10-year in equal monetary amounts. If the spread widens due to credit-negative influences in the market, it's expected that both BBB-rated bonds and the 10-year will sell off collectively. But due to the latter's "safe haven" status, the BBB-rated bonds would depreciate to a greater extent. It's also, of course, possible to make a positive return on the trade if the 10-year appreciates more than the BBB-rated credit in the case of a credit-positive event.
So if one wanted to put this trade on if/when the spread contracted to 100 bps and wanted to hold until it rose to the mean expectation of 180 bps, the gain on this trade would be around 6.5%-7.5% on an unleveraged basis depending on how each leg of the trade performed. It would also depend on the type of instrument traded. One could go with the actual bonds themselves, or choose an ETF such as (MUTF:PBBBX). (The ETF on the Treasury side of the trade would be IEF).
#2: Higher Risk
One could also go up the risk curve toward junk bonds (NYSEARCA:HYG), which could potentially provide more upside. In the current market, the spread between high-yield and the 10-year Treasury is the lowest it's been since September 2014 at 345 bps, based on the measurement used by BofA Merrill Lynch. One year ago, this spread was at 800 bps largely due to oil hovering below $30 per barrel and its effect on the energy sector.
During the financial crisis, this spread peaked at around 2100 bps, much higher than the 747 bps mentioned above with the lower-end investment-grade debt. (The spread appears lower than 2100 bps in the graph below given the data is aggregated by month rather than at the daily level).
(Source: BofA Merrill Lynch)
So naturally for those who believe turmoil of some form is forthcoming, taking this trade instead may be compelling, as it provides greater reward. Historically, this spread has never materially drifted too far below 250 bps. And considering the risk profiles between US corporate high-yield bonds and 10-year US Treasuries, the spread should never be below 250 bps, in my opinion. A spread that low is excessively optimistic even in seemingly perfect economic conditions.
The average spread between the high-yield and the 10-year has been 547 bps over the past 16 years, with 473 bps as the median. (The extreme conditions that characterize credit shocks skew the mean higher than the median).
So if one were to put on this trade at a spread of 310 bps (if it materializes), and obtain a convergence back to 473 bps, one could expect to make 11%-15% unleveraged depending on what moved where. If the expectation is that 250 bps represents the worst-case scenario, then we could expect around 4%-5% downside on this trade. Of course, I can't guarantee that 250 bps is a floor, but it's gotten around that level four times in the past twenty years and has acted as a type of support level each time.
I like the high-yield spread trade better, as it can yield better results. Also, I believe that it's simply in a better position due to the current appetite for risk-taking that has bid down yields among junk bonds. Although the high-yield/Treasury spread is at 19-month lows, I wouldn't be inclined to take this trade at the current level. If the spread were to winnow down to 300-310 bps, I feel like it would be worth taking.
These types of spread trades are designed to take advantage of mean-reverting phenomenon. The market is definitely slanted toward the "greed/euphoric" stage at the moment, which is bidding down the spreads between risky and risk-free assets. For example, I have the stock market estimated to return just 3.9%-4.3% in real terms moving forward.
Yet a lot of the growth we see among corporations, and in the global economy generally, isn't sustainable. China's credit growth of 12%-13% year-over-year has helped other economies grow as well, but will need to be ratcheted down to avoid credit bubbles. US corporate debt as a percentage of GDP is higher than it's ever been at over 31% of GDP.
(Source: Board of Governors of the Federal Reserve System; modeled by fred.stlouisfed.org)
Stocks have largely increased not because of earnings growth, which has been flat to down over the past two years, but due to share buybacks fueled by cheap debt. Corporate tax cuts and repatriation of overseas cash could pay for themselves, but higher infrastructure spending and military expansion will likely push the budget deficit higher from its mark of 3.2% of GDP in 2016. This will push the national debt higher, which is already at $20 trillion and 108% of GDP, and limits future growth prospects.
The US and developed world generally is at the most indebted point in its history on both an absolute and relative scale. While this can stimulate some level of growth, a longer-term approach might recognize that the ongoing spread dilutions between "risk-free" and risky assets are likely to revert in time when credit is expanding at a faster rate than nominal economic growth.
Nonetheless, in terms of risk/reward dynamics, I would only enter into trades of this sort should the spread(s) tighten even further, and I have no positions in anything mentioned.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.