Are High Yield Bonds Overvalued Right Now?

February 16, 2017 | ,

High yield bonds enjoyed significant tailwinds in 2016:

• During the year, the price of oil stabilized.
• U.S. shale oil exploration and production defaults and bankruptcies worked their way through the pipeline and most are now behind us.
• Trump’s win, with his promises of tax cuts and infrastructure spending, boosted investor confidence.
• OPEC’s production cut agreement further added to the risk-on sentiment.

All of this fueled a 17.1% return for high yield bonds during 2016, as measured by the Barclays U.S. Corporate High Yield Bond Index. Of course, “bond math” dictates that returns for any sector of the asset class have a ceiling on price escalation, and high yield bonds may be in overvalued territory right now. As we can see in this week’s chart, spreads¹  — which are a primary valuation metric for bonds — are tight at the moment, at 388 basis points on January 31 for the Barclays U.S. Corporate High Yield Bond Index compared with its ten-year average of 606 basis points. In other words, current high yield bond spreads are more than 200 basis points tighter than long-term average spreads. If we exclude the financial crisis years of 2008 and 2009, the long-term average spread is 508 basis points and current spreads are still considered tight. Current spreads are about as tight as they were prior to the shale oil crisis of 2014-2015.

High yield spreads typically compress to the point when a market correction occurs. This market correction typically features spread widening. Because of such tight spreads at the moment, as well as other fundamentals that we track such as aggressive use of proceeds and aggressive lower-quality issuance, spreads are more likely to widen than further tighten. As such, we recommend that clients reallocate to policy weights and maintain a cautious and conservative outlook for high yield bond allocations.

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¹ Defined as the excess yield above U.S. Treasury bond yields