Tuesday, March 6, 2012
My last post on this subject was in mid-January, and my main points then were that 1) although credit spreads were still elevated, this did not imply a risk of imminent recession, and 2) high-yield bonds were still attractive since yields were a little over 8%. Since then, spreads have come down somewhat, but they are still at levels that prevailed at the onset of the last recession, as shown in the chart above. Yields have come down to record-low levels, but as I argue below, they remain attractive.
One crucial point I made back then is still valid today: the reason spreads are elevated is not because default risk is rising or of great concern, it's because Treasury yields have collapsed. In other words, the market is priced to the expectation that the whole economy is going to be in miserable shape in coming years, not that any one sector is necessarily more risky than another. As the two charts above show, A1 industrial spreads today are substantially above the levels of the mid-1990s, but yields are orders of magnitude lower (1.54% today).
A similar pattern can be seen in the above chart, which compares 2-yr swap spreads to the yield on 5-yr generic High Yield Credit Default Swaps. Swap spreads are about as low as they get, which tells us that systemic risk in the financial markets is very low and liquidity is very high, yet spreads on HY CDS are still quite elevated. As before, I would argue that the still-elevated level of junk spreads is not an indicator of impending recession, as it has been in the past. Rather, it presents the high-yield investor with a conundrum which is undoubtedly contributing to keeping spreads as high as they are: do you buy HY debt for the attractive spread, or do you sell HY debt because yields are so low?
As this next chart shows, junk bond yields are now at all-time lows (7.1% today). The cost of borrowing for the typical "risky" company has never been cheaper. Ordinarily, this might be a signal for investors to sell junk bonds, but since the alternative sources of yield are also at record lows, and the spread from high-quality to junk yields is still quite high, the rationale for exiting the junk bond market is weak. The Fed is leaving investors with little choice but to move out the yield curve and accept more risk, since the incremental rewards to doing so are significant. In contrast, high-quality yields offer very little to the average investor, but they are a boon to the average high-quality borrower.
Posted by Scott Grannis at 10:45 AM