Inside the High-Yield Spread
High yield is not pricing a recession
By: Greg Obenshain
The high-yield spread is the extra yield over Treasurys that investors demand to lend to non-investment grade borrowers. We believe it is one of the best barometers of current financial conditions. Wide spreads mean money is dear and investors fear losses. Tight spreads mean loose financial conditions with investors competing for investments.
In a year when corporate and government bonds had terrible returns and an inverted yield curve has been warning of an upcoming recession, you’d think that the high-yield spread would be very wide. But you’d be wrong. Below we show our historical measure of the high-yield spread. The thin line is where the high-yield spread is today. The current value of 4.3% is just above the long-term median of 4.2%.
Figure 1: The High-Yield Spread Over Time
(Gray bars are NBER dated recessions. Dotted line is the current level of spreads.)
Source: Fred BofA High Yield Spread since 1997, Bloomberg Barclays index from 1987 to 1997, and Verdad estimates from FRED data prior to 1987
There was a moment in May 2022 when credit spreads crossed above their long-term median and we warned of increasing non-linear downside risk. Indeed, by June, high-yield spreads rose to almost 6%, and we wrote that high yield might be a good first buy. But by the end of the year, spreads had come back down to more normal levels. The Bloomberg high-yield index did indeed generate a 3.5% return over the following six months versus a 1.6% loss for investment grade, but this wasn’t the juicy buying opportunity we were hoping for.
So, if not widening spreads, where did the terrible returns for the year come from? It was almost all due to Treasury rates, which rose throughout the year. We can see this in the chart below that breaks corporate bond returns into their rate component and their credit component (price loss due to spread widening).
Figure 2: 2022 Corporate Bond Returns by Rating Category (BB, B and CCC Are High Yield)
Source: Bloomberg
CCC credit did indeed have losses due to significant spread widening, but the other rating categories had relatively minor losses given the horrible performance of almost all asset classes in 2022.
So, what should we make of the high-yield spread today? Is it abnormally tight given the environment, or is something else going on? One possibility is that the composition of the high-yield spread is different than it has been in the past. We are fond of pointing out that a higher percentage of the market is rated BB rather than B than in the past. Our view is that this is largely because of the development of the loan market and private credit market, which have taken on the growth of more highly leveraged lending.
Below is the historical composition of the high-yield market by rating. Note the increasing share of BBs.
Figure 3: Rating Composition of the High-Yield Market
Source: Bloomberg
Could the increased percentage of BBs affect the comparability of the current spread to historical spreads levels? To test this, we constructed historical spread series for each rating level. Each month, we used our debt database to estimate the credit spread for each rating category at every duration point, thereby creating a set of monthly rating curves. Using this, we can extract the spread for a specific rating at a specific duration point.
Does this approach produce meaningfully different results than just using the broad high-yield index, with its shifting rating quality and duration profile? The answer is, no, not really. Below we show the spread for the B rated bonds at the five-year duration point versus the high-yield index spread. B is the midpoint of the high-yield ratings scale, so we’d expect it to track the high-yield index spread closely, and we’d expect to see the high-yield index line fall below it if the increasing percentage of BBs were skewing the index. Clearly, this is not happening. The lines track each other. The index is telling a story consistent with that of the underlying ratings curves.
Figure 4: B2 and BB2 Spreads at the 5Y Duration Point
Source: Bloomberg, Verdad bond database
But with this data, we can do a much more interesting analysis and look at the full ratings curve in both high yield and investment grade over the entire history. Below we show two curves. The green bold line is the median ratings spread curve since 1996. This is the median spread for each rating category at the five-year duration point. The thin black line is the same curve but only for NBER recession months.
Figure 5: Median and Recession Ratings Curves
Source: Verdad Bond Database
So how does today’s rating curve compare to the long-run median and to the recessionary median? We show the answer below.
Figure 6: Current Ratings Curve vs Median and Recession Ratings Curves
Source: Verdad Bond Database. Data as of 12/31/2022.
The entire corporate credit market, including high yield, except CCCs, is at median spread levels. And in the first few months of January, this curve has shifted further down. What’s an investor to do when the yield curve signals a recession but the best measure of corporate stress does not? Which one is right?
The yield curve has the best track record, but the economist that first described the indicator believes it’s giving a false signal. But the yield curve doesn’t predict recession next month: it’s a leading indicator, and the gap between yield curve inversion and recessions can be long. Right now, credit spreads are suggesting default risk is about normal in the high-yield market.
And with the three-year Treasury yields at 4% and three-year BB bonds offering 2% on top of that, there is a 6% return for three-years that seems highly probably to be realized in an uncertain economic environment.
We don’t know how this will resolve. One signal portends a coming recession, but the other suggests that markets are sanguine about this. Fortunately, we believe higher rates make it profitable to buy relatively short-dated bonds (Treasury, corporate, or both) and wait.