March 23, 2020

Spreads Above 700, Now What?

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David Jackson
Portfolio Manager

High yield bond spreads are 10.71% vs treasuries as of 3/25/20, elevated above the historical median of 4.89% due to macroeconomic uncertainty. It should be noted that elevated spread levels above 7% are rare, and have historically provided high yield bond investors with an entry point for outsized return potential.

Credit spreads have historically impacted future return potential. For example, when the option-adjusted spread (“OAS”) of high yield bonds vs treasuries reached 7% (as they have currently) over the last 25 years, high yield bonds returned 51.1% (8.6% annualized) over the next 5 years on average while the aggregate bond market returned 22.8% (4.2%).


High yield bonds have historically offered an attractive risk-return profile, earning a long-term spot in an optimal portfolio. But for the purpose of setting return expectations, as well as consideration for more tactical investors, credit spreads at entry play a key role.


Historical Spread Distribution and 5 Year Forward Return
ICE BofA High Yield OAS Index - Inception Dec 1996 to Mar 2020
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Source: Bloomberg, Spreads: ICE BofA High Yield OAS Index. Indices: ICE BofA High Yield, BbgBarc Aggregate Bond


Current spread levels are elevated relative to the historic median of 4.89% amid heightened levels of macroeconomic uncertainty. High yield investors should consider longer holding periods of at least 5 years to reduce outcome volatility, as well as the average, minimum, and maximum of forward returns relative to spread levels.


ICE BofA High Yield Option-Adjusted Spreads and 3-Year Forward Return
​​​​​High Yield Spreads and 3Y Forward Return
Source: Bloomberg. As of 3/20/2020.


Starting Spreads vs 5-Year Forward Returns (12/31/96 – 2/29/20)
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Source: Bloomberg, Spreads: ICE BofA High Yield OAS Index. Indices: ICE BofA High Yield, BbgBarc Aggregate Bond


For those seeking to remain indifferent to spread fluctuations and entry point dynamics, BB-B rated short duration bonds have historically exhibited durability to both. The bonds have also exhibited notable durability to interest rate, recession, volatility, and other macroeconomic fluctuations.


5 Year Returns vs Starting Credit Spreads – Last 20 Years
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As of 2/29/2020. Source: Bloomberg, Indices: S&P 500, ICE BofA High Yield, ICE BofA BB-B 1-3Y, BbgBarc Aggregate Bond, ICE BofA BBB 1-3Y.


In conclusion, credit spreads at the point of investment entry should be considered when setting strategic return expectations and for tactical alpha potential. But “timing the market”, or calling spread tops/bottoms, is a difficult endeavor. High yield investors seeking to reduce the risk of credit spread fluctuations can focus on long-term investment horizons, optimal entry points, and/or BB-B short duration bonds.

A PDF Version can be found here.

 

 

 


 

 

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