Vimal Gore is BT Investment Management’s Head of Income and Fixed Interest. In his latest monthly newsletter he spent a good part of it discussing the high yield market. The high yield market comprises debt securities which are sub-investment grade. That is, they have credit ratings below BBB- (S&P) or below Baa2 (Moody’s). Naturally they have a higher yield than investment-grade securities and this is why some investors are attracted to them.
The higher yield comes at a price, however and on average, high yield securities are much more likely to default. Gore quotes an S&P observation about companies with debt rated B- or lower; these companies “are on average ten times more likely” to default than companies rated B through to BB+.
The difference between the benchmark yield and the yield on a particular security is known as the spread. In the case of corporate bonds this difference is often referred to as a credit spread. Gore explained the existence of the spread as a reward for the additional risk pointed an investor takes on. “Credit spreads are the portion of bond yields that compensates the investor for the default and volatility risk they are taking when buying the bond.”
So what minimum spread which makes up for this risk of default? According to Gore, in the U.S. it should be around 3%. He explained his calculation in the following manner. “The long term average default rate for US high yield is around 5%, and the average recovery rate achieved by investors is around 40%. This translates to expected losses…of 3%, or 300bps.”
So on average, across many different issuers and over various time periods, a diversified portfolio of high yield bonds will suffer losses equal to around 3% of the portfolio per annum. (Note to readers: “events” are often bunched in particular years with no events in others. Averages tend to disguise this.)
The point of Gore’s article is how the spread has come down to not much more than 3%. “Buying US high yield credit at a spread of 330bps thus only provides a 30bps cushion for volatility.” Investors expect a higher return not only for risk but for a greater degree of variability of their portfolio values. (Would you expect a lower, equal or higher rate of return from an asset where you know the value will not change between now and the maturity date or an asset in which its value is uncertain until the maturity date?)
Currently, he thinks 30bps is too little premium for the volatility and he points out an expansion in the spread may lead to price falls in high yield bonds. “The margin for error seems awfully thin. When high yield spreads are priced for perfection, small knocks to the status quo can cause big moves.”
So he has a warning for investors in this part of the bond market. “When the risks are so well known, and the rewards so unrewarding, why are investors still reaching for yield in the junk yard? The easiest answer is that timing the end to low volatility is impossible, and calling it too early is painful.”
He does not think it will always be this way. However, for now, there are safer places to be. “There will also come a time when value returns to the land of high yield. Until then, we say ‘no’ to collective lunacy. We have no fear of missing out. We think there are alternatives.”
The full article can be found here.