The case for high yield rests largely on the fact that it remains one of the few asset classes left that can offer a greater than 5% yield. Spreads (the difference between the yield of a high yield bond and a U.S. Treasury) have come in considerably since the winter lows. But relative to Treasuries, high yield still provides a spread of around 540 basis points (5.4%), close to the long term average (source: Bloomberg). It is true that if you strip out energy companies, spreads are a bit tighter. This suggests that while high yield pricing is not particularly daunting, the easy money has already been made. Historically, the best time to buy high yield is when spreads are wide, such as earlier this year when spreads briefly climbed over 800 basis points (source: Bloomberg).
Market Realist – Yield spreads have narrowed.
Spreads are a gauge of the market-implied default risk. A rise in spreads indicates worsening credit conditions, whereas a narrowing reflects the market’s confidence that defaults are less probable or less common.
Yields on high-yield debt (HYG) (JNK) and spreads between high-yield debt and Treasuries both fell over the last year. High-yield debt yields, represented by the BofA Merrill Lynch US High Yield Master II Effective Yield, fell 4 basis points and ended at 6.4% on August 26, 2016. It was the lowest since June 24, 2015.
Like yields, the option-adjusted spread also fell last week. The BofA Merrill Lynch US High Yield Master II Option Adjusted Spread fell 6 basis points last week. It ended at 5.1% on August 26, 2016, the lowest since July 24, 2015.
In the next part, we’ll analyze the impact of the economic outlook on junk bonds.