As the economy recovers, will spreads tighten faster than Treasuries expand?

10 Year Treasury Yields vs 10 Year BB Index 2013-04-29Enlarge Graph

During the first half of the year, spreads have compressed while Treasuries contracted. This behavior is not normal, and it is actually opposite of the normal relationship between interest rates and spreads.

Understanding whether spread tightening will outpace Treasury rate expansions can help high yield bond investors estimate how much lower the yield on bonds can go and, hence, protect the bond price from dropping. The yield of a bond is composed of the underlying yield on the equivalent maturity Treasury bond and the spread to that Treasury bond’s yield (e.g. Bond Yield = Treasury Yield + Spread to Treasury). In big strokes, the Treasury yield component accounts for the tenor risk of the corporate bond (since Treasury bonds are risk free, investors only need to be compensated for time) and the spread accounts for the relative riskiness of the corporate bond versus a Treasury bond with a similar maturity.

Historical analysis

Historical analysis, and a bit of common sense, tells us that spreads and Treasuries, while independent of each other, both depend on a third variable: overall risk perception of the economy. During good times, interest rates expand as investors shift demand from bonds into riskier assets; spreads narrow since those riskier assets are perceived as less volatile. During bad times, the opposite happens: interest rates contract as demand for bonds increases, and spreads widen as investors flee the riskier asset classes.

Looking at the daily BAML High Yield Index’s yield-to-worse values, and comparing against the 10 year Treasury rate for the same timeframe, we find that since mid last year, spreads have contracted 1.5x faster (on average) than what Treasuries expanded. This was much lower than the 1.3x for the first half of 2012, as well as the much lower values prior to that1.

Why the party may be over

While this may led us to believe that future behavior should follow a similar ratio and, hence, there are several arguments against it in the medium term:

  • It is not normal behavior, which means the anomaly will be corrected eventually to adequately price the inherent risk in high yield bonds, though the amount of time this will take may be longer than expected
  • The anomaly has persisted long enough that spreads have contracted more than they should have, so there is very limited room for further contraction
  • Interest rates and Treasury yields have been artificially maintained at record lows by quantitative easing, which, when phased out, will spring rates up

What now?

A prudent investor would start reducing their exposure in bonds throughout Q2 before quantitative easing starts getting phased out in the latter half the year. For those still bullish on tight spreads based on the analysis here, then perhaps leveraged loans would be an option; loans pay floating interest rates that are not affected by rising interest rates but are also exposed to a similar level of credit risk as high yield bonds.2.

In the short term, the spread anomaly may persist and the Federal Reserve may keep pushing interest rates down, but it is likely that by the Fall of 2013 things will start to show clear signs of change.

  1. During 2011, spreads moved on average 1:1 with Treasuries.
  2. Both high yield bonds and leveraged loans are debt securities rated below investment grade, though loans are secured by assets, which means they have slightly less risk.