High-Yield In Name Only
· The decline in the average yield of high-yield bonds to a new record low is cause for caution but not panic.
· High-yield bonds still stand out in a low-yield world, but recent action suggests a closer look at bank loans is warranted.
High-yield bonds may be “high-yield” in name only now. Robust demand for corporate bonds pushed the average yield on high-yield bonds further into record-low territory, closing at 5.75% last week. A mid-single-digit yield just does not seem that “high,” especially for a bond sector that has regularly offered investors double-digit yields and whose yield has averaged 9.9% over the past 20 years. In fact, the average yield of high-yield bonds is now below the long-term 5.9% average yield of their higher quality investment-grade corporate bond cousins, according to Barclays Index data. And just two years ago, long-term high-quality municipal bonds yielding just over 5% were not difficult to find.
An average yield below 6% on high-yield bonds should raise caution but not alarm. The high-yield bond market is merely following in the footsteps of other bond sectors that breached record-low yield territory in recent months and years. In 2010, the average yield of investment-grade corporate bonds and mortgage-backed securities (MBS) dropped to new record lows, according to Barclays Index data. In 2011, intermediate Treasury yields fell to new record lows, and late that year, high-quality municipal bond yields joined the record club. High-quality bond yields descended further into record territory in 2012, and by September of last year, the average yield of the Barclays High Yield Bond Index reached a new record low as well and, like other bond sectors, continued its journey lower.
The average yield drop to a new record low must be taken in this context of a low-yield world. The extraordinary policies of the Federal Reserve (Fed) have been a driving force: first, by lowering overnight lending rates to near zero, and second, by embarking on unprecedented bond purchases that not only reduced available bond supply but also motivated investors into higher yielding debt.
Amid this backdrop, high-yield bonds still stand out in a low-yield world with average yields that are still six times greater than comparable Treasuries [Figure 1].
Figure 1: Despite Lower Yields, High-Yield Bonds Still Stand Out in a Low-Yield World
High-yield bond valuations have become more expensive but remain far removed from 2007 levels that preceded the financial crisis. The average yield advantage, or spread, of high-yield bonds to Treasuries contracted to 5.1% last Friday [Figure 2] due to Treasury weakness coupled with high-yield bond strength. The average yield spread is below the 5.8% long-term average but certainly not representative of the lofty valuations that preceded the financial crisis when the average yield spread bottomed at 2.6% in June 2007.
Additionally, the following factors are supportive of high-yield bonds maintaining slightly higher valuations: