Consider The Spread: When To Buy Corporate Bonds

Corporate Bonds: Figuring Out A Fair Price (Part 2 of 5)

(Continued from Part 1)

One way to think about corporate bond valuations is to consider the spread. Investors in corporate bonds are assuming credit risk – the risk that the issuer won’t repay the principal or make good on an interest payment. Investors are arguably not subject to that risk with a Treasury bond (for all its troubles, the US government has never defaulted).

Market Realist – When to buy corporate bonds.

The graph above shows the spread between ten-year Treasuries (IEF) and high yield bonds (JNK)(HYG) rated CCC or more over the last ten years. The spread is the difference between the yields of the two bonds.

Junk bond yields increase when the probability of their issuers defaulting, increases. This usually happens when the economy is in a tough place. When this happens, the probability of default increases. This is because the issuers are usually small companies and have few resources to endure such times, eventually defaulting.

On the other hand, Treasuries are considered safe havens, as they’re backed by the full faith and credit of the government. So, when the economy is in bad shape, investors flee away from risky assets like equities (SPY)(IVV) and high yield bonds and towards safe havens like Treasuries and gold (GLD)(IAU).

For example, during the financial crisis, investors ran away from high yield bonds and towards Treasuries, increasing the yields of the former and lowering those of the latter. The spread at the peak of the crisis was a whopping ~45% as high yield bond prices tumbled.

However, during these situations, it’s fear that drives spreads so high. During these times, spreads are driven to ludicrous levels. Corporate high yield begins to look attractive. Although you can never time the markets, the large spread levels should serve as a green flag—especially if the economy starts recovering. Sure enough, within a year of the crisis, spreads tumbled to saner levels.

Continue to Part 3

Browse this series on Market Realist:

• Part 1 - Why Corporate Bonds Look Reasonably Priced

• Part 3 - How Various Asset Classes Compare Using Risk-To-Return Relations

• Part 4 - High Yield Bonds Outperform When The Economy Improves