The Race to Zero in High Yield Credit

More interesting commentary on the fixed income markets and high yield bonds.  This time from our friends over at Surly Trader:

“The average annual credit loss in high yield bond portfolios was 2.65% between 1992 and 2011.  During that same time period, your average yield for taking that credit risk was 10.25% and your average option adjusted spread was 5.7% .  Today, that total yield has dropped to 4.96%.

At 4.96% you are picking up 4.04% above a comparable tenor in US treasuries.   With a 2.65% average credit loss, you are expecting a 1.39% risk premium for taking on junk credit risk if we experience historical average credit losses.  Do not worry though, because volatility has been removed from all asset classes.”


High Yield – The New Risk Free Asset Class



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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  1. I still say one high profile default will chase everyone out of this market. There’s a reason they’re referred to as “junk” bonds.

  2. Does anyone have a sence of how much new supply of junk bonds is being issued? With yields so low, presumably demand is far outstripping supply; so are many company’s who issue weak paper able to take advantage of these yields, or have gains mostly just accrued to those who bought up junk bonds through the last 4 years. Who are the companies issuing junk bond and what are they using the funds for? Refinancing/retiring old junk bond issues at much lower rates perhaps? How much of this low junk bond yield is actually exiting out in to the real economy to finance investment?

  3. There is an article in today’s FT on this:

    I thought it was interesting that the default rate for high yield bonds is at a low of 0.5% (last year), which is down from 7.4% in 2009 and 15.9% in 1990.

  4. The Fed can bring speculators into this market only reluctantly and with great effort, but they will (attempt to) leave quickly in sauve qui peut mode when a few issues fail. As you point out, the rewards of holding the paper to maturity don’t balance with the risk of default–so one needs to assume some capital gain to balance it out. One might suggest that the smart money will start selling if prices level out–they do not even need to fall.

    To me, this is one of the problems with the Fed (or any other central bank) intervening to pump up asset prices “higher than they otherwise would be.” The issue is not increasing prices–anyone can do that–the trick is to convince other holders that the price increases will continue; otherwise, there is no reason to continue holding the asset after the price increase has occurred. One might suggest that the assets wind up in weak hands under this scenario–weak hands being agents who rely on asset price increases in order to compensate them for holding the asset.

  5. Won’t the Fed step in and buy junk bonds if prices fall? I know, crazy, but the Fed took over Fannie and rescued MBS holders.

  6. I’d love to see some more nuanced detail on high yield corporates. For example, when I ran the data recently, the spreads were down close to – but not as low as – the historical lows from the past two expansions when they dropped below 4%.

    Granted, it certainly seems that there may be more potential downside vs upside from here, but I am of the opinion that rising interest rates may not be as bad for HY corporates as some tend to imply. If Treasury rates are rising meaningfully, it’s because the Fed has raised the FFR and that is going to happen because of reduced unemployment and economic growth – both positives for corporate fundamentals, I’d think.