High Yield Corporate Bonds: We’ve Been Here Before

Tuesday January 26, 2016 | By Terri Spath

Ever since the last of the revelers headed home from their New Year parties, it’s been a “risk-off” atmosphere for asset classes around the globe. For at least a full year and into 2016, the party has been well over in the high yield corporate bond market.

The chart above shows the spread of high yield corporate bonds over the past several years.¹ Recently, the spread on high yield bonds increased to over 800 basis points (bps) versus only 350 bps in the middle of 2014. An increase in spread is equivalent to an increase in yield and thus a decline in the prices of high yield corporate bonds.

As long-term investors in the high yield corporate bond market, we have seen this level of spreads before. So what happened next?

J.P. Morgan published a study recently examining how high yield corporate bonds fared over the past 25 years after reaching a spread of 800 bps. Notably, total returns were remarkably strong, on average 24-25%.

The current situation in high yield may be similar to late 2011, the last time we saw spreads this wide. At that time, the world was nervous that the European Union may not survive. Spreads peaked at over 900 bps and the 12 month return following that time was 19.5%.

Although energy issues pose a problem for the high yield corporate bond sector, much of the rest of the asset class is financially solid. Based on historical behavior of this asset class, the current climate may, in hindsight, prove to be an opportunity to buy and certainly not a time to sell.

¹ A consistent way to look at high yield corporate bonds is to study their spread, or the additional yield paid, versus a comparable risk-free Treasury bond.