The option adjusted spread on the ICE BofA US High Yield index closed at 266 basis points on September 21. That is the extra yield, above a matched Treasury, that investors are accepting to lend to companies rated below investment grade. The long run median for that measure is near 450 basis points, and the current reading sits in the richest decile of its history.

Investment grade tells the same story. The broad index trades near 81 basis points and the BBB tier, the lowest rung of investment grade, near 100. The ratio between high yield and investment grade is about 3.3 times, which is close to its long term average, so this is not one segment behaving strangely. The whole credit market is priced for calm.

The spread and the yield are two different things

This is the distinction that matters most and the one most often collapsed. A high yield bond's total return has two components: the Treasury rate underneath it and the spread on top. With the ten-year at 4.96%, the all in yield on a typical high yield portfolio is somewhere near 7.5%, which is a genuinely attractive number and far better than anything available in 2021.

The spread is the part that compensates you for the possibility that the borrower does not pay. At 266 basis points, that compensation is thin. Historical default rates on below investment grade credit average somewhere in the mid single digits across a full cycle, with recoveries well under par, and 2.66 percentage points a year does not obviously cover that once you account for the years when defaults cluster.

So the honest description of high yield right now is a good yield attached to poor compensation for risk. Those two facts coexist because the risk free rate is doing the work that the spread used to do.

Asymmetry is the whole argument

Whitmore's Watchlist:
HYG (iShares iBoxx $ High Yield Corporate Bond ETF): The standard liquid expression of the asset class, duration included.
SHYG (iShares 0-5 Year High Yield Corporate Bond ETF): Shorter maturities, less interest rate risk, closer to a pure credit bet.
BKLN (Invesco Senior Loan ETF): Floating rate loans sitting above bonds in the capital structure.

From 266 basis points, the tightest readings in modern history are somewhere around 230. So the best case from here is perhaps forty basis points of further compression, worth a point or so of price on a typical portfolio.

The other direction is not symmetric. Spreads reached 1,100 basis points in 2020 and above 2,000 in December 2008. They do not need a crisis to move a long way; an ordinary recession has historically taken high yield spreads to 800 or more. The distribution of outcomes from here is a small gain against a large and fat tailed loss, which is the textbook definition of a poor risk reward even when the central case is fine.

None of that is a forecast. Spreads can sit in the richest decile for years, and they did through much of 2005 to 2007 and again from 2017 to 2019. Being early in credit is expensive, because the carry you give up while waiting is real and the event you are waiting for may not arrive.

What actually changes the picture

The trigger for credit is not the level of rates, it is the ability of borrowers to service them. Watch the maturity schedule rather than the spread. A below investment grade issuer that borrowed at 5% in 2021 and must refinance at 8% today faces a real increase in interest expense, and the share of below investment grade debt maturing over the next two years is the practical constraint.

Watch the loan market alongside the bond market too. Senior loans float, which means their borrowers have been absorbing every Fed increase in real time rather than waiting for a refinancing date, and distress tends to appear there first.

Where this leaves an allocation is a question of what the position is for. Held for income, at 7.5%, high yield does the job. Held as a diversifier against equities, it does not, because it falls when equities fall and by a similar amount at exactly the wrong moment.

Whitmore's Take: A 7.5% yield and a 266 basis point spread are two different statements, and only one of them is good. Worth deciding whether you own credit for the income or for the cushion, because at these spreads it can only provide the first.

Written by Daniel Whitmore
Millionaire Insiders