At what point does junk start to look like diamonds in the rough?
There’s no clear answer, but it’s a topical question whenever a financial squall blows through the capital markets and risk is repriced. It’s clear that we’ve suffered a storm of late, but it’s debatable if risk has been repriced on a dramatic scale.
Risk, for purposes of this post, is defined as the spread in high yield bonds over 10-year Treasuries. By that measure, junk commands a premium of 4.37% over the 10-year as of Friday’s close, as per Citigroup High Yield Index over Treasuries. The 4%-plus is significantly higher than the 2.6% spread offered by Mr. Market at the end of June, as our chart below shows. But while the rise looks impressive in the context of recent history, it’s still debatable on whether it also looks compelling enough to commit fresh capital to the asset class.
Deciding if junk’s spread now looks rich enough to compensate for risk depends on one’s confidence in the future. For those who believe that the economy will continue growing at a healthy if not necessarily exciting pace well into next year, the prospect of earning 400-plus basis points over Treasuries may entice. Indeed, the current spread is the highest in more than two years. And 400 basis points of additional yield is nothing to sneeze at when compounded over, say, a decade.