High-yield bonds are a steal

I suggested a few weeks ago that the big decline in short-maturity swap spreads was a good leading indicator of a coming rally in high-yield (i.e., junk) bonds. So far that prediction hasn't born fruit, as this chart shows. But I also noted that sometimes the lag between swap spreads and other spread assets can be significant. It may well be the case that junk bonds are just going to be slow to react to what I view as a significant improvement in the underlying fundamentals.

Be that as it may, with junk bond yields now well over 20% (Lehman says the average junk bond yielded 22% last Friday, whereas Bloomberg says it was 25%), it's time to look at these bonds in isolation. Junk bond yields have never before been this high. Just what does that mean for an investor?

According to Moody's, the current default rate for junk bonds is about 4%. They expect it could rise to 10% by the end of next year, which is close to the all-time high cumulative default rate in the Depression of 14%. Let's say their decidedly pessimistic assumptions are right. Now, considering that defaulted junk bonds are likely to have a recovery value of at least 30% (which is very conservative), that means that an investment in junk bonds today is likely to incur losses of 10% * 70%, or 7% over the next year. In other words, you would lose 10% to defaults, but recover 3% of that as the defaulted companies liquidate their assets. So if you buy junk bonds today that are yielding, say, 22%, you can expect to receive, over the next 12 months, an income return of 22% less a loss of 7%, for a net return of 15%. And that's using some pretty pessimistic assumptions.

What would it take for an investment in junk bonds today to equal the essentially zero rate of return on cash today even if default rates are horrendous? The yields on junk bonds would have to rise from 22% today to about 26% for the one-year holding period return of junk to equal the current yield on cash. That's because an increase in the yield on junk bonds of 4 percentage points implies a price drop on those bonds of almost 15%. So things have to deteriorate meaningfully for an investment in junk to equal an investment in risk-free cash.

If junk yields don't increase at all, they will produce a return of 15% in the next year. If junk yields decline from 22% to 20% (a drop in the bucket if things in general start to improve), then junk returns will be almost 23% in the next year. If junk yields don't increase for a month, then an investment in junk bonds will produce a one-month return of at least 1.2%, which beats the annual yield on most money market funds! How much longer can investors ignore these numbers?

In short, it's not enough to be pessimistic these days in order to be bearish on the prospects of corporate bonds and equities. You have to be downright convinced that conditions in the next year are going to be far worse than anything the U.S. has ever seen.

As for investor psychology, all it would take for things to improve signficantly is for them not to deteriorate. Because if current yields hold steady, the returns to taking risk will rapidly undermine the confidence of those who are hiding out in cash.