March 17, 2009
Investors salivate at the thought of a diversified asset class offering 20% returns. That is the stuff of which legends are made.
It also describes junk bonds, more euphemistically known as the high yield sector. Historically, high yield bonds have traded at less than 400 basis points above comparable Treasury bonds. Today, those spreads have spiked to between 1,600 and 2,000 basis points, as the chart below illustrates (courtesy of Northern Trust):
Considering that these spreads are above and beyond the 3% yields 10-year Treasury bonds already earn, it’s not hard to see why this sector is drawing a lot of attention
High-yield spreads typically spike in recessions. But today’s spreads are far larger than in either of the previous two recessions (1990 and 2001), when spreads peaked around 1,000 basis points.
That means the average high yield bond now trades at 60% on the dollar, well below its previous low of 68%.
Depressed asset prices - fueled by irrational fears - are pushing the flow of funds into the high yield sector.
“Since mid-December investors have been gradually returning to the high yield market,” said Zane Brown, a Lord Abbett fixed income strategist. “Mutual fund flows have been consistently positive and spreads have narrowed from 2,100 basis points above Treasuries to 1,800 basis points now, still a compelling valuation level. Current spreads of 1,800 basis points far exceed previous record wide spreads of 1,100 to 1,200 basis points in the recessions of 1991 and 2002. Current spread levels imply default rates of 18 to 24%, compared to the actual rate of about 12% in the recessions of 1991 and 2002.”
Default is the ultimate risk faced by high yield investors. Were it not for the possibility of defaults, there would be no question whether these bonds are undervalued.
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