What to Buy First Redux

When spreads widen to crisis levels, high yield can be an attractive first buy

By: Greg Obenshain

In March of 2020, as high yield sold off dramatically, we started to write a letter called What to Buy First that we published on March 23. By sheer coincidence, the publication marked the low point of the high-yield market, which went on to return 34% over the next 12 months. In that article, we argued that investors should strongly consider allocating to the high-yield bond market and particularly BB credit.

Our argument was simple. The combination of high yields, wide spreads, and bonds that must pay off at 100 by contract greatly increase the probability of attractive returns. Investors get paid to hold an asset that is likely to appreciate. Given that high-yield spreads are once again nearing the 6% level, an area that we consider a crisis level, it is again time to take a close look at high yield.

Figure 1: High-Yield Spreads Once Again Approaching Crisis Levels

Source: BOA High Yield Index via FRED

As of June 30, the high-yield market offered an 8.9% yield. This is the highest level since the end of March 2020, when the yield was 9.2%. But the path to this level has been very different this time, and the opportunity is very different.

In March of 2020, almost the entire yield came from credit spreads, as rates had plummeted along with a collapsing growth outlook. The market was concerned about the ability of borrowers to pay and was pricing in a default wave. As a result, most of our analysis focused on historical levels of default and by how much we should reduce our return expectations for expected losses. Below we show just how much of the yield came from credit spreads, not Treasurys, in early 2020.

Figure 2: Yield on High-Yield Index Broken into Treasury Yield and Credit Spread (Q1 2020)

Source: BOA High Yield Index via FRED

The increase in yield during the first quarter of 2020 was due entirely to spread widening. The Treasury component fell throughout the quarter. In March of 2020, the snap back in credit came because the Fed was able to act decisively, even buying credit directly to limit credit risk contagion.

The situation today is different. Over the past six months, the Treasury portion of the yield was first to move. Only recently, especially in the past month, has the spread component started to rapidly widen. Despite the longer selloff, we may still be early on in the credit-widening environment.

Figure 3: Yield on High-Yield Index Broken into Treasury Yield and Credit Spread (H1 2022)

Source: BOA High Yield Index via FRED

Inflation has changed the story. Today, with the Fed constrained by the risk of inflation, it is not at all certain that they will be able to act as aggressively to reduce default risk—nor is it at all clear that they will be successful in containing inflation. High yield could continue to get hit from both sides.

Indeed, just hitting 6% spreads does not guarantee high forward returns. Credit spreads can continue to widen and rates can continue to rise. But high spreads make it increasingly difficult to lose. Below we list the dates at which high-yield spreads hit 6% over the past 30+ years. We show the drawdown to that point and the subsequent returns.

Figure 4: Returns from Point When High-Yield Spreads Hit 6%

Source: BOA High Yield Index via FRED, Verdad Analysis

Notably, in 1998, 2000, and 2008, returns were either lackluster or even negative for a year. In many of these cases, the best return opportunities came after high-yield spreads continued to widen past 6%. So 6% is not a magical level above which high returns result. Rather, it is the beginning of the period when investors should start to pay attention.

It’s time to start swinging a little closer to greed than fear, but how can we do this intelligently? One way to do this is to look at a map of yields and see what we are getting paid for the risk. Below we show the yields on corporate bonds by rating category and years to maturity.

Figure 5: A Map of Yields in Corporate Credit

Source: Bloomberg, Verdad Analysis

To read this chart, start by moving down the list of credit ratings on the left-hand side. Anything BBB and above is investment grade, the rest is high yield. Yields rise non-linearly as ratings fall, but so do risks. Those incrementally higher yields at the bottom are more than offset by bad outcomes. In normal environments, the risk-reward is not attractive, as we argued in Fool’s Yield. They can be exceptionally attractive in times of crisis, but we’re not there yet.

Reading across the top, we show yields to increasing maturities, a proxy for the fixed-income concept of duration. There is very little incremental yield for taking duration risk. Why not? This partially reflects the Treasury yield curve, which is flat, but it also reflects the reality of how fixed income works. Once they are being compensated for credit risk, investors may be happy to lock in a relatively high rate for a longer period of time, especially if they are trying to match known liabilities (in the case of insurance companies or endowments with fixed payouts). Also, because the best borrowers can issue longer-dated debt and the weaker ones cannot, the long-duration portion of the universe tends to have the stronger borrowers. This can be a terrific place to invest when credit spreads start to tighten as duration increases the price gains from falling yields. Again, we are not there yet.

For those not looking for levered credit risk or risky credit, that leaves the green box. Investors can now buy BB or BBB bonds with five years or less to maturity paying 4-7% yields. Unlike yields on crypto, these are real. They are being generated by large companies with low historic default rates, and, by contract, they must pay you all your money back in just a few years. Boring and relatively safe: exactly what bonds are supposed to be.