There have been a number of reasons investors have fled the high yield bond market over the past year, including concerns over interest rates, energy and commodity exposure, liquidity, and defaults. With this sell off, spreads have now increased to multi-year highs, putting spreads over 200bps above historical median levels.¹

Not only are spreads at multi-year highs and well above historical medians, we are now sitting at yield levels also above historical medians despite the well-below average interest rate environment we are facing. With the current spread level, investors are getting a 339% premium for being invested in high yield bonds versus 10-year Treasuries.²

Historically speaking, this premium is on the high end, excluding the massive spike we saw in the midst of the 2008/2009 financial crisis. This indicates that investors are getting a sizable yield relative to the risk-free Treasury rate.

Looking at other fixed income segments, the spread differential between high yield bonds and investment grade bonds is also well above historical average and median levels.³

Obviously the default environment is a factor when investors consider making an allocation to the high yield market versus investment grade bonds or “risk-free” Treasuries. However, as we have noted in other writings (see our piece “Implied Default Rates for the High Yield Market” and “Assessing Default Risk, Yield Matters”), we believe that default rates will increase but will stay below historical averages and investors are being more than compensated for expected default losses.

Additionally, as investors assess their fixed income investment alternatives in the face of what we expect to be a moderate interest rate increase over the next year (see our piece “Interest Rates: Moderate is the Word”), duration, a measure of interest rate sensitivity, also must be considered.⁴

The high yield bond market not only offers investors a yield more than double what is offered by the investment grade bond market, but also provides a lower duration, meaning it would face less interest rate risk as rates rise.

Given the historically high spreads currently offered in the high yield space and the lower interest rate risk per the lower duration, we believe investors should be considering an allocation to the high yield market as they assess their fixed income allocations.  We believe there is an opportunity cost to holding Treasuries or investment grade bonds in terms of the missed yield offered by high yield bonds.  Also keep in mind that if you expect interest rates to increase, for Treasuries that means that as rates/yields rise that translates to a price decline and we believe investment grade bonds also face outsized interest rate risk.

Of note, the yields and duration referenced above for the high yield market are for the index.  However, as an active manager, we can work to focus on value based on our fundamental analysis and credit selection, which has resulted in even higher yields and a lower duration in our portfolio, as we combine both high yield bonds and loans.  We believe that after the big repricing we have seen over the last year, today’s high yield debt market offers active investors attractive yield and value.

1 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, December 18, 2015, p. 29.

2 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, December 18, 2015, p. 30.

3 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield Research, December 18, 2015, p. 30.

4 Barclays Capital U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. U.S. 5 Year Treasury Note is the on-the-run Treasury (source Bloomberg). Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements. Data as of 12/30/15 for the various Barclays indexes, source Barclays Capital, and 12/31/15 for the U.S. 5 Year Treasury Note. Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration is a modified adjusted duration for the various Barclays indexes and Bloomberg calculated duration to workout for 5-Year Treasury.