Equities are not the only asset class defying gravity these days. The past 18 months have witnessed stellar performance from most risky assets, including U.S. high yield. With the economy on solid footing and financial conditions still relatively loose, investors are relying on several arguments that this happy state of affairs will continue:
2017 has been a year dominated by momentum trades, such as high yield. Barclays High Yield Index returned approximately 17% in 2016. Depending on the index you use, it is up another 6% to 7% in 2017. In short, investors have done extremely well sticking with this trade.
Yield in a yield-starved world
The yield on U.S. high yield has slipped as spreads have compressed. At 5%, high yield does not seem to offer particularly generous returns, especially when you consider that the long-term average is closer to 10%. Still, a 5% yield looks enticing given the alternatives in other bonds.
As with stocks, high yield bonds have had a remarkably quiet year. According to Bloomberg, trailing 30-day volatility on two popular high yield ETFs is below 3%. Longer-term measures of volatility are also compressed. This is important. Low expected or ex-ante volatility historically translates into a high expected Sharpe Ratio. In other words, with realized and expected volatility unusually low, high yield appears attractive on a risk/return basis.
What could lead to a less benign outcome? As it turns out, a number of things, although admittedly none are likely to derail the asset class in the near term. However, those with a longer-term horizon should take note of historically tight spreads, rising corporate debt and lower credit quality.
The first problem is that high yield is expensive, arguably very expensive.
The spread that investors are currently receiving, i.e. yield above a comparable maturity Treasury, is unusually small. Since bond yields move down when the price of the bond goes up, this is usually a sign the bonds are getting pricey. How much? Since 1994 the average spread has been approximately 515 basis points (or 5.15 percentage points). Today the spread is around 350 bps. This is the lowest level in more than three years. Current levels are also starting to approach the lows witnessed just before the financial crisis. See the accompanying chart.