Fridson: Yield curve inversion versus high-yield spread

This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to Leveraged Commentary & Data.

On Aug. 30, Jonathan Levin, CFA wrote an excellent Bloomberg Opinion piece titled, “Junk bond traders ought to check in with economists.” He described the prevailing spread on US high-yield corporates as “paltry,” given the risk of owning them in the face of a looming recession. “Either spreads need to widen or the recession clouds need to vanish,” he continued, “but something’s got to give.”

Levin calculated fair value for the HY spread-versus-Treasuries by an impeccably sound method. At the time, the median recession probability estimated by Bloomberg-surveyed economists was 50%. That meant the appropriate spread, by Levin’s reckoning, was the midpoint between a non-recessionary +325 bps and a mild-recessionary +800 bps. The answer, +563 bps, was 111 bps greater than the +452 bps spread on the index Levin used, as of the date of his article. Levin then offered possible explanations for the “disconnect” he found between the present recession risk and the speculative-grade risk premium.

We agree that with the currently inverted Treasury yield curve emitting a classic signal of an oncoming recession, the high-yield spread will probably be biased toward widening over the next several months. At the same time, it bears mentioning that the ICE BofA US High Yield Index’s Sept. 2 option-adjusted spread (OAS) of +506 bps was not anomalous, based on historical data. The table below details what happened in the past when the two-to-ten-year Treasury curve was inverted at month-end by an amount within plus/minus 5 bps of the negative 21 bps differential observed on Sept. 2.

Note that effective yields and OAS data are not available for the index prior to Dec. 31, 1996. For the 1989 observation, we therefore calculated the yield curve based on yield-to-maturity (YTM) and quantified the spread as the YTM differential between the ICE BofA US High Yield Index, which had an average maturity of 11.28 years at the time, and the ICE BofA Current Ten-Year US Treasury Index.

In both 1989 and 2006, the high-yield spread was substantially narrower than at present, despite a yield curve inversion of similar magnitude. The counterexample comprises three months of 2000 within a four-month span, representing a single observation for all intents and purposes. That period represented the aftermath of the collapse of the early-stage telecom issuers. Telecom had been high-yield’s largest industry sector. The widening of the ICE BofA US High Yield Telecommunications Index’s OAS from +563 bps on Feb. 29, 2000, to +1,354 bps on Nov. 30, 2000, exerted a contagion effect that contributed to the ICE BofA US High Yield ex-Telecom Index’s widening from +551 bps to +826 bps over the same interval.

Whatever interpretation one may offer for the 2000 episode, it is indisputable that there is historical precedent for a high-yield OAS at least as low as +506 bps in conjunction with a Treasury curve that is inverted by about 20 bps. There is consequently no need to search for unique aspects of the current environment that explain the coexistence of such a small speculative-grade risk premium with a classic leading indicator of recession. It is the norm, rather than the exception, for the high-yield market to refrain from fully pricing in recession risk until the wolf is at the door, or at least climbing the porch steps. The recent OAS widening to +506 bps suggests that the market has spotted the lupine figure advancing on the pathway leading up to the front porch.

Research assistance by Zhuojun Lyu and Yinuo Lai. 

ICE BofA Index System data is used by permission. Copyright © 2022 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.

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This article originally appeared on PitchBook News