Economic News & Analysis—June 18, 2014
Is high yield overvalued?By James Kochan, Chief Fixed-Income Strategist
It has become a standing joke in the media that we can no longer call junk bonds high-yield bonds because the yields are too low. More serious commentaries suggest that after a five-year rally, the high-yield market has become substantially overvalued and, therefore, it is no longer an appropriate investment category for most individual investors. This point of view looks at the overvaluation question and concludes that a more conservative approach to credit risk might now be warranted.
Is the high-yield market actually overvalued? It depends on which credit segment you’re looking at.A popular measure of high-yield valuations is the average yield from the indexes that include the full universe of high-yield bonds. Today, the BofA Merrill Lynch High-Yield Index shows an average yield of only 4.98%, which matches the all-time low reached last May, just before yields moved sharply higher out of fear of Federal Reserve (Fed) tapering. Because Treasury yields are 50 to 75 basis points (bps; 100 bps equals 1.00%) higher now than they were last May, spreads to Treasuries are now much narrower. The 4.98% yield is only 240 bps above the yield on the 10-year Treasury note, the narrowest spread ever. Over the 2004–2007 period of low junk-bond yields, that spread never fell below 250 bps, and it averaged 325 bps. This has led many observers to conclude that junk is overvalued.
A more disaggregated look at yields and spreads suggests a less bearish conclusion. While yields and yield spreads for the CCC-rated and weaker credits are now at record lows, that is not the case for the stronger credit segments.
The average yield on the 10-year BB credits is now around 5.90%, which is approximately 60 bps above the 2013 low and approximately 330 bps above the 10-year Treasury yield. That spread to Treasuries was as low as 200 bps from 2004–2007, and it averaged 265 bps over that period. The typical range for this spread in those years was 200–300 bps. By these standards, the BB-rated credits do not appear to be overvalued.
The average yield for the 10-year B index is now 6.05%, versus a low of 5.20% in 2013. The 345-bp spread to the 10-year Treasury is well above the 275-bp low of 2004 and 2007 and slightly above the 335-bp average spread over those years. The typical range for the B-rated spread in 2004–2007 was 275–375 bps. The current spread would not, therefore, mark the single B-rated segment as overvalued.
The story is different for the weakest credits. The 7.45% yield on the 10-year CCC index is 35 bps lower than the previous low in 2013. The 475-bp spread to the 10-year Treasury is 25 bps greater than the low reached in 2007, but it is far less than the 600-bp average for this spread over 2004–2007. Moreover, the typical range for this spread back then was 500–700 bps. This credit segment could now be regarded as overvalued versus Treasuries.
Put today’s high-yield environment in historical perspective.It is important to note that most junk-bond yields remained at or near the cyclical lows over much of 2004–2007. They did not rise, despite Fed tightening from mid-2004 to mid-2006. They did begin to increase when the credit fundamentals began to weaken in the second half of 2007. Today, most measures of credit fundamentals are quite healthy. Defaults have been unusually low and are projected to stay low in 2014 and 2015. The so-called wall of refinancing has been pushed out to 2016–2017. Corporate cash flow is expected to remain strong, as long as the U.S. economy continues to expand, and none of the leading economic indicators are signaling an end to this cyclical expansion.
It may be too early for investors to become overly defensive.The high-yield market faces conflicting forces. Yields are low and yield spreads are narrow, while the outlook for credit fundamentals still appears to be positive. The yield relationships might suggest a reduced exposure to high yield, while the outlook for credit argues against an exit from this asset class. We believe that it is too early to exit the high-yield market but that a more conservative credit strategy is now appropriate. We would recommend underweighting the CCC-rated and weaker credits and would no longer recommend the longest-duration strategy.
We still believe it is too early in the business/interest-rate cycle for investors to become overly defensive. We recommend investing for income, not safety. Compounding that interest income over the next two to three years would, in our opinion, result in better total returns than could be realized through cash or cash equivalents. Since high yield produces the best income in the domestic taxable markets, we would expect conservatively managed high-yield portfolios to continue to outperform very short-duration portfolios over the next 12 to 24 months.