So what does this mean for investors? We have been neutral on high yield (HYG) for the past few months as it has offered more income potential than other asset classes. High yield remains a potential source of income in a diversified portfolio, but potential price appreciation is limited.
Market Realist – The graph above shows the correlation between CDS spreads and high yield option-adjusted spreads (or OAS).
The S&P/ISDA CDS U.S. High-Yield Index has been taken to indicate CDS spreads. It shows the average spreads required to buy protection against 80 equally weighted U.S. entities (according to S&P Dow Jones Indices). A higher index level means that purchasing default protection has become more expensive.
High yield (JNK) option-adjusted spreads and CDS spreads generally move hand in hand since a wide divergence can open up the possibility of arbitrage, which the market will quickly take advantage of and eliminate.
Both CDS spreads and OAS drastically increased at the end of July. The high correlation in the recent drawdown may point to a solid move rather than a one-time drawdown. You could attribute this high correlation to a decreasing appetite for credit risk by investors who are now turning to investment grade bonds (LQD)(AGG) and Treasuries (TLT)(IEF). This trend could continue, so there’s likely to be limited possible price appreciation in high yield bonds.
The recent sell-off is also a good reminder to investors of the potential volatility of the asset class. Given current yields, investors have to weigh whether they are being paid enough to take on this volatility and the underlying credit risk. Another consideration is whether recent price movements represent a temporary setback for the high yield market or the beginning of a broader re-pricing of corporate bonds. Given overall economic conditions I doubt that there will be any contagion into investment grade debt. For now, I continue to be neutral on high yield.
Market Realist – Read our series Why investors should watch for asset class deception to understand the risk of investing in high yield bonds.
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