Yahoo Finance High Yield Bonds Outperform When The Economy Improves
Corporate Bonds: Figuring Out A Fair Price (Part 4 of 5)
In general, when the economy is stronger, spreads tend to contract as investors are less worried about companies defaulting. Conversely, when the economy is weaker investors should receive a higher return to compensate for the risk of increased defaults (as you would expect, defaults rise in recessions).
So when it comes to evaluating how wide the spread should be, start with your view on the economy. By comparing your view of the economy to current spreads, you can get at some rough measure of “fair value.”
Market Realist – High yield bonds outperform when the economy improves.
The graph shows yields for high yield bonds (HYG)(JNK,) along with year-over-year GDP (gross domestic product) growth rates. They’re almost a mirror image of each other, suggesting that high yield bonds perform well when the economy improves. This should be intuitive, as corporate earnings improve along with the economy, which means that default rates fall. The credit spread narrows, and yields improve. Investors jump from low-yielding Treasuries (TLT)(IEF) to high yield bonds.
On the other hand, when the economy is down, the chance that high yield bonds could default increases—as we mentioned earlier—and so do credit spreads. Investors re-allocate their funds from risky assets like high yield bonds and equities (SPY)(IVV) to much safer assets like US Treasuries. This results in a spike in high yield bonds.
On the other hand, Treasury yields would move in a pattern similar to GDP growth. Remember, yields and prices move in opposite directions. Treasury yields are low when GDP growth rates are low, as this is a risk-off scenario.
So, when the economy is showing signs of improvement, you need to shift to corporate bonds—especially high yield bonds, which perform the best within fixed income—as spreads narrow.
Browse this series on Market Realist:
