Chart of the Week: High-Yield Bonds Say Not To Panic

Jeffrey DeMaso

Portfolio Manager

Signs of investor panic seem to be everywhere. Whether it’s the Cboe VolatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in. Index (Wall Street’s “fear gauge”) earning prime placement on newscasts, traders amping up purchases of puts (a bet that the market will fall) or simply reading recent investor surveys, fear is the dominant sentiment. I understand the unease.

One glaring exception to this apparent gloom can be found in the high-yield, or “junk bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates.,” market. When bond investors fret about the market and the economy, they typically flock to safe assets (e.g., Treasury bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates.) and flee risky assets (like junk bonds, which have lower credit ratings due to their higher default riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline.). The net result is that junk bond yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. rise faster than those available on safety-oriented Treasury bonds. The difference in yields is known as the yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. spread, or “spread.”

A wide spread between junk bond and Treasury bond yields typically indicates investor fear. Yet, while yields on junk bonds have risen to around 9.5%, their spread over Treasurys has not grown dramatically because Treasury bond yields have also been on the rise. At 5% or so, the spread is bigger than it was at the beginning of the year—a sign that investors are more nervous than they were. But it’s not particularly wide by historical standards. Typically, in times of stress and heightened levels of investor fear, the spread has reached 8% or more.

So, while the junk bond market suggests investors are on edge, we also conclude that traders are not overly worried about the road ahead. Meanwhile, stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. markets and investor sentiment surveys suggest bearishness matches levels seen during the early days of the COVID-19 outbreak as well as the global financial crisis of 2007–2009. Is it stock investors or bond investors who have it right? Only time will tell, but we’ll continue to keep an eye on junk bonds, both for opportunities and as a potential signal for what’s to come.