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Against all odds, the high yield bond yields ended last week setting a new record low.
The average yield for the BAML High Yield Index was at 5.5%, after having started the year at record lows around 6%. To put it in perspective, the high yield bond market is supposed to be composed of the riskiest debt securities, and they’re yielding almost what the 10 year Treasury was yielding back in 2007. The market had never dipped below 7%, but the returns on the week ended lower.
What triggered it? Insanity, or the Fed?
The Federal Reserve minutes pointed to an earlier phasing out of quantitative easing during the second half of 2013. Before the announcement, the time the yield1 on the BAML HY Index was at 5.7%.
Somehow the 10 year Treasury actually went down from 1.8% to 1.7% instead of up, given the increased expectation of higher rates. Other Treasury maturities along the shorter end of the curve moved by similar amounts. This contributed to an approximate 0.1 percentage point reduction in high yield bond yields. This is the insane part: immediately after the announcement rates did increase, but then dropped. The only explanation that comes to mind is the possible massive purchase of Treasuries by the Fed to counteract the potential rates spike.
The other 0.1 percentage points contraction came from a tightening of high yield bond spreads to Treasuries2. This could be justified if the Fed minutes were interpreted as giving a brighter outlook of the economy, and, hence, reduced risk.
How to take it?
Rational investors would actually see this as a buying opportunity to either short high yield bonds or buy leveraged loans. High yield bond prices are bound to go down once rates increase, while leveraged loans will benefit from the rates increase since they pay a floating interest rate that adjusts as interest moves up or down.
The insanity cannot go on much longer, but times like this remind investors that “the market can remain irrational longer than the investor can remain liquid.”
© 2013 Market Realist, Inc.