This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to Leveraged Commentary & Data.
On Aug. 30, Jonathan Levin, CFA wrote an excellent Bloomberg Opinion piece titled, “Junk bond traders ought to check in with economists.” He described the prevailing spread on US high-yield corporates as “paltry,” given the risk of owning them in the face of a looming recession. “Either spreads need to widen or the recession clouds need to vanish,” he continued, “but something’s got to give.”
Levin calculated fair value for the HY spread-versus-Treasuries by an impeccably sound method. At the time, the median recession probability estimated by Bloomberg-surveyed economists was 50%. That meant the appropriate spread, by Levin’s reckoning, was the midpoint between a non-recessionary +325 bps and a mild-recessionary +800 bps. The answer, +563 bps, was 111 bps greater than the +452 bps spread on the index Levin used, as of the date of his article. Levin then offered possible explanations for the “disconnect” he found between the present recession risk and the speculative-grade risk premium.
We agree that with the currently inverted Treasury yield curve emitting a classic signal of an oncoming recession, the high-yield spread will probably be biased toward widening over the next several months. At the same time, it bears mentioning that the ICE BofA US High Yield Index’s Sept. 2 option-adjusted spread (OAS) of +506 bps was not anomalous, based on historical data. The table below details what happened in the past when the two-to-ten-year Treasury curve was inverted at month-end by an amount within plus/minus 5 bps of the negative 21 bps differential observed on Sept. 2.
Note that effective yields and OAS data are not available for the index prior to Dec. 31, 1996. For the 1989 observation, we therefore calculated the yield curve based on yield-to-maturity (YTM) and quantified the spread as the YTM differential between the ICE BofA US High Yield Index, which had an average maturity of 11.28 years at the time, and the ICE BofA Current Ten-Year US Treasury Index.
In both 1989 and 2006, the high-yield spread was substantially narrower than at present, despite a yield curve inversion of similar magnitude. The counterexample comprises three months of 2000 within a four-month span, representing a single observation for all intents and purposes. That period represented the aftermath of the collapse of the early-stage telecom issuers. Telecom had been high-yield’s largest industry sector. The widening of the ICE BofA US High Yield Telecommunications Index’s OAS from +563 bps on Feb. 29, 2000, to +1,354 bps on Nov. 30, 2000, exerted a contagion effect that contributed to the ICE BofA US High Yield ex-Telecom Index’s widening from +551 bps to +826 bps over the same interval.