The 10-year Treasury yield’s recent move has high yield bonds looking more attractive on a relative basis. Earlier in the year, high yield levels sat at 5% vs. 2.5% for the 10-year Treasury. That relationship has changed to nearly 6.5% for high yield vs. 2% for the 10-year Treasury. As such, high yield bonds offer a better value, particularly as high yield defaults should remain muted for the time being.
Market Realist – The graph above shows the Bank of America Merrill Lynch U.S. High Yield Option Adjusted Spread over U.S. Treasuries (TLT)(IEF) and the effective yield. Credit spreads usually remain tight in periods of expansion. But as you can see above, the spreads have widened in October even as the U.S. economy has continued to strengthen. This is in part due to the low U.S. Treasury yields prevailing in the economy, which are in turn due to low yields in international markets (QWLD). The other reason is that U.S. high yield bonds funds have seen many outflows in the year, resulting in increasing yields.
Market Realist – The graph above shows the weekly high yield bond fund flows over the past quarter. High yield bond (JNK) funds saw outflows of $549 million in the week ended October 17, 2014.
As the economy continues to strengthen, the default rates on fixed income instruments are likely to remain low. High yield bonds (HYG) look like a good investment opportunity on the basis of relative valuation.
Read on to the next part of this series to learn why you should include municipal bonds in your portfolio.