In recent days, several articles have questioned whether high-yield bonds and leveraged loans still offer enough potential return to compensate for their higher credit risk. Some of the articles have suggested that credit risk has been increasing, especially in the leveraged loan sector. When a market experiences heavy inflows, issuers are often able to structure deals without what had been standard protective covenants. Ordinarily, investors would be compensated for the absence of these covenants but not in a sellers’ market such as today.
A cursory glance at spreads to Treasuries would suggest that the risk/reward trade-off does not favor these high-yield issues. Yield spreads are some of the narrowest for this cycle. After exploding upward in 2008, spreads narrowed sharply in 2009 and have been fluctuating within relatively narrow ranges over the past 12 months. For the BB-rated and B-rated 10-year maturities, current spreads are 250–275 basis points and 300–325 basis points, respectively. They are slightly greater than the narrows for this cycle seen early last year. For the CCC sector, however, the current 425–450 basis point spreads are the narrowest of this cycle. By this measure, the weakest of the high-yield credits, which have performed best since 2008, are now relatively expensive.
Taking a longer view, most of the current yield spreads are not exceptionally narrow. From 2004 through the first half of 2007, spreads to Treasuries in the 10-year BB segment were 50–75 basis points narrower than now. For the B-rated 10-year corporates, spreads were 25–50 basis points narrower. For the CCC sector, however, spreads are now equal to or slightly narrower than the narrowest spreads of 2004–2007. This longer view also finds the weakest credits to be somewhat expensive.
Past performance is no guarantee of future results.
It is important to note that even at those narrow spreads, high-yield bonds performed well from 2004 to mid-2007, even as the Federal Reserve (Fed) raised the federal funds rate by 425 basis points. Annualized total returns ranged from 7.4% for the BB sector to 12.0% for the CCC credits. Over that same period, the Treasury market recorded an annualized return of 3.0%. Even in the face of Fed tightening, high-yield bonds performed well until concerns about a possible recession and an attendant increase in default risk emerged in the second half of 2007.
Because high-yield bonds and leveraged loans have performed so well over the past five years, it is understandable that some observers would question whether those markets still offer acceptable risk/return trade-offs. The 2004–2007 experience suggests, however, that it might be too early to abandon those markets. Except for the CCC and weaker credits, spreads to Treasuries are still wider now than in that period. Underweighting, rather than abandoning those weaker credit sectors, might be the more prudent course. The 2004-2007 experience also suggests that the greater coupon income from high yield could continue to produce positive total returns should short-term interest rates move upward. In high yield, default risk is much more important than interest-rate risk. And Moody’s is predicting very low default rates for at least the next 12 months.