High Yield is Now Expensive

I’ve seen a number of articles recently arguing that high yield bonds are still cheap. Today I began an investigation to analyze this claim.

Here’s my bias: at the first investment shop I worked in, the high yield manager told me that there is a nominal yield for high yield bonds which reflects the risk.  It doesn’t matter where Treasury yields are, high yield bonds don’t care.  As a result, when people in the media, or writing blogs those argue that high yield is cheap because yield spreads are wide, it is time to disregard then when Treasury yields are artificially low, because of government interference.  (Financial Repression)

High yield bonds do care about credit conditions.  High yield bonds do care about the stock market.  From all of my research, high yield bonds are highly sensitive to credit conditions, particularly those of its industry.  They are also sensitive to the stock market.  After all, if the high yield bonds are doing badly, the stock is doing worse.

And here’s the rub: high yield bonds do not react to yields on Treasuries, except negatively, because when Treasuries rally hard, times are not good, and high yield bonds do poorly, with yields rising.

Here’s a graph to show how yields have done over the last 15 years for various corporate bond ratings.

My data this evening comes from the Federal Reserve Bank of St. Louis’ website FRED.  Been using it for 20 years, it is one of the best economic data repositories on the web.  Even used it during the bulletin board era, pre-web.

Merill Lynch has recently provided many of its bond yield indexes to FRED.  Previously, all that was there were two long yield series from Moody’s.

Now, if the concept of yield spreads is valid, when I do regressions of treasury yields on corporate index yields, I should see tight correlations of the yields versus Treasuries, and beta coefficients near one.  Here’s what I obtained:

High Yield is Now ExpensiveAAA-CCC refer to ratings categories.  HYM is High Yield Master II, which is an average of high yield bond yields, and is usually very close to single-B yields, no surprise.

As you will note, spreads work reasonably to poorly for investment grade bonds.  The yields on investment grade bonds do not fall as much as yields on Treasury bonds do.  The yields on high yield bonds are barely affected when Treasury yields fall.  Look at the R-squareds on the regressions versus Treasuries only, high yield bonds do not have any economically significant relation ship to Treasuries alone.

Thus, it doesn’t make sense to talk about high yield bonds in terms of spreads over Treasuries.  High yield bonds react more to lending conditions, and derivatively, how well the stock market is doing.

But if we introduce credit spreads into the analysis, everything changes, and R-squareds skyrocket.

To me, BBB bonds are the touchstone for credit conditions.  Why?  They are on the edge of investment-grade creditworthiness.  They are also a large part of the corporate bond market.  When their yields rise or fall, it is a sign that financing rates for corporations are changing.

So, when I did regressions including BBB yields in addition to 5-year Treasury yields, guess what?

  • Junk yields were highly geared to BBB yields.
  • When Treasury yields fall, junk yields rise, and vice-versa.
  • These relationships are in general more statistically significant than those of high investment grade corporates versus Treasuries.

So what does this prove?

  • Yield spreads over Treasuries are not a good way to define value in bonds, and particularly not junk bonds.
  • Better to analyze high yield bonds versus BBB bond yields, and consider Treasury yields as a negative factor when rates are low.

So, is high yield cheap or dear at present?

Whether I look at the Merrill High Yield Master 2, BBs, or Bs, junk bonds look expensive.  CCCs look a little cheap.  The yields on the High Yield Master 2 look about 0.8% expensive in terms of yield (that’s the residual in the above graph).  I will be lightening credit bond/loan positions in the near term.  Of course this is just my opinion, so do your own due diligence.

And, please realize that movements in the stock market may swamp my observations.  If the stock market runs, high yield can run further… but there will be an eventual snap-back.   The bond market is bigger than the stock market, eventually the stock market reacts to bond market realities.



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.