The Current High Yield Spread – What to make of it?

Hit by a sharp downturn in investor sentiment, US high yield spreads have widened to levels last seen since 2011. Back then, slowing (even negative in Q1) growth and the escalation of the European debt crisis, caused a long-lasting sell off in junk bonds. Spreads more than doubled to almost 900 basis points. This time around, it’s the price of oil that’s spooking investors. Ever since the peak in oil prices, back in June 2014, spreads have continued to widen. As a result spreads have again doubled, reaching a high just shy of 800 basis points, recently. What can we make of the current high yield spread?

First, high yield spreads of above 750 basis points are pretty rare. At the time of writing the spread on the Barclays US Corporate High Yield Index was very close to this level. Since the start of the Barclays Index in 1994, the ‘end-of-month’ high yield spread topped this threshold just 31 times, out of a total of 261 months. To clarify, up until 2000 spreads were published only once every month, hence the end-of-month spread level.

Second, and this gets most attention obviously, high yield returns following end-0f-month spreads of 750 basis points have been massive As the table below shows, high yield has significantly outperformed when things really looked ugly. Historically, returns were 2.5 – 3 times the historical average.

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Third, and this should be taken into account as well, the 31 observations are heavily centered around two big recessions, one following the Dot-com bubble burst and one following the subprime crisis. This skewness has a profound impact on the results, although the ‘non-recession 750 basis point event’ of 2011 was followed by a big return on high yield as well. The graph below shows the results for a 12 month horizon, but the picture is comparable for the other periods. Also note that for all periods negative returns can still occur.

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Fourth, it seems hardly likely that all of the 31 months mentioned above would be ‘available’ for an actual, real-time, trading strategy. For example, if an investor puts all of his money in high yield bonds for a period of 12 months, immediately after the end-of-month spread hits 750 basis points for the first time, the next 11 end-of-month spread levels are irrelevant to him. He can’t act on spread levels when he is already fully invested. For an investor with a 3-month horizon, the next two signals are of no use, and so on. When I correct for these real-time investment implications, the outperformance of high yield shrinks significantly, and becomes negative for the 9 and 12 month horizon. Now, I should add here that the significance of these numbers is debatable as the number of real-time investment periods for the 9- and 12-month horizon is reduced to just 7. However, it does reveal that the simple average of returns draws a rosier picture than the one actually achievable for investors. There is, of course, a pretty straightforward explanation for this phenomenon. Chances are that the spread will keep rising after it hits 750 basis points for the first time. With a full investment strategy your are bound to be too early!

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