The biggest challenge in strategic-minded investing lies within. The high-yield bond market of late offers a telling example.
Trailing yields on junk bonds have soared recently, as our chart below shows. The risk premium on junk over 10-year Treasury Notes exploded skyward to close yesterday at nearly 15%. That’s the highest since the early 1990s and, one could argue, it looks enticing.
The human mind, meanwhile, is a complicated organ. What looks like far better values today relative to, say, June 12, 2007 isn’t necessarily obvious or compelling to homo economicus. We cite June 12 of last year because that was the trough for the junk/Treasury yield spread, as per Citigroup High Yield Index.
Not long after, we remained suspicious that the spread was sufficiently high to compensate for the risks ahead, as per our post in late summer 2007. As it turned out, we weren’t wary enough, not by a long shot. We did, however, say that even though the risk premium had risen to a bit over 4% in August 2007, “we’re not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets.” In fact, we should have told everyone to run for the hills and put everything in cash. Hindsight, as always, tells us exactly what we should have done.
As it turned out, the crowd had other ideas, which is to say bullish ideas. Indeed, the late summer of 2007 was a strong period for the junk bond market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for instance, had a run higher in August and September of that year, reaching an all-time high of $104.70 on September 25, 2007. The ETF closed yesterday at $71.40.
Having been crushed, the high-yield bond market now offers its highest trailing yield in a generation. We’re guessing, but it seems as though there are few takers, if any. Yes, there’s reason to shun junk bonds, starting with the high odds that a painful and lengthy recession awaits. If so, defaults on junk will rise. Understandably, that scares off the bulls. And for all we know, staying scared may be the only logical decision at this point. An economy that takes a beating will treat the lower-grade tier of securities harshly, even after the harsh treatment to date.