For the second day running, the yield on the 10-year Treasury yesterday closed under 4.8%. That hasn’t happened since March.
Traders of government bonds have become increasingly optimistic that inflation isn’t half the threat it was perceived to be in weeks past. In concert with that forecast, the 10-year’s yield has dropped roughly 20 basis points from the 5.0% level of August 14. Although many disagree with the trend and instead fear that inflation will continue to harass the economy, for now the fixed-income set is convinced that it knows what’s coming, and the world can either follow or get out of the way.
No matter what you think of the decline in yield, the trend is being felt elsewhere in the capital markets. That includes the market for high-yield debt securities, otherwise known as junk bonds.
Among the byproducts of the falling bond yields is a rise in the spread of junk yields over the 10-year’s. The KDP High Yield Index currently carries an 8.0% yield, which translates into a spread of roughly 3.2% over the 10-year Treasury. The spread is highest since the second half of 2005, and up about 70 basis points from earlier this year, according to KDP Advisor.
The rise in the junk spread is encouraging for those looking at high yield bonds. But encouraging does not yet convince us to buy, even if we’re finding more incentive to look. Indeed, a 320-basis-point spread is the richest so far this year. Alas, it still pales next to levels from recent history. In the first half of 2005, for instance, the spread touched ~400 basis points, based on the KDP High Yield Index, as the chart below shows (courtesy of KDPAdvisor.com) And back in 2002, an astonishing spread of nearly 900 basis points could be had, albeit for a brief and fleeting moment.
KDP High Yield Index Spread over 10-Yr Treasury

Source: KDP Advisor
Of course, no one should expect a 900-basis-point spread to return any time soon. The monetary and economic climate has changed drastically since then, all but insuring that far-more modest spreads are likely to prevail for the foreseeable future.
Nonetheless, for those smart enough to dive in junk bonds in mid-2002, the subsequent returns have been remarkable, as the trailing returns remind. For the past five years through yesterday, for instance, the Merrill Lynch U.S. High Yield Master II Index has earned an annualized total return of 8.3%, or more than double the S&P 500’s rise over that span, according to Morningstar.com. Bonds overall, as measured by the Lehman Bros. Aggregate, have also trailed, posting an annualized total return of 4.85% for the five years through yesterday.

But if there’s worry that junk bonds still aren’t offering an enticing spread over Treasuries, the anxiety isn’t obvious in 2006. The Merrill Lynch U.S. High Yield Master II Index so far this year is up 5.6% on a total-return basis–virtually identical to the S&P 500’s year-to-date performance and well ahead of the Lehman Aggregate Bond’s 1.8% advance through yesterday.
The recent rise in the junk-Treasury spread is due primarily to the fall in the 10-year’s yield. As a result, the trailing 7.43% yield currently offered in Vanguard’s High Yield Corp. Fund, for instance, is looking more attractive by the day. Just how attractive such yields will ultimately become appears to be a function of sentiment among Treasury traders. And for the moment, those traders are intent on giving investors ever-more alluring spread opportunities.
If the trend keeps up, it may be time to consider a fresh deployment of capital into junk bond funds. We’re not there yet; then again, the boys in the Treasury pits aren’t quite done chasing government bonds. All of which is inspiring us to keep a close eye on spreads.