Looking To Figure Out Where Junk Bonds Are Headed? Watch The Dollar

I want to return again to the topic of high yield spreads. It’s something I’ve talked about a number of times over the past few months because I believe it’s an important risk signal that could indicate one of two things - 1) the proper entry point to achieve above average returns in subsequent years and 2) a potential exit point where the risk/reward tradeoff is no longer attractive.

The argument I’ve made in recent times is that, while high yield spreads in a vacuum are already at near-record lows and offer very little potential for capital growth, conditions that favor higher volatility - the Fed backing off stimulus measures, the upcoming battle over the debt ceiling, high current inflation and/or longer-term deflation - could be not far off into the future.

Let’s set the table by looking at the history of the high yield corporate bond spread over the past quarter century.

I put that bottom red line at the 3% level where, historically, has been the general floor for high yield spreads. Yes, there have been cases where it’s gone below that level, but it hasn’t stayed there for long before moving back up into its long-term range. On the upper end, high yield spreads generally top out around 9%. That, of course, isn’t a hard ceiling, but it suggests the rough level where most of the worst case scenario is priced in and the risk/reward opportunity looks favorable again in the coming years. If you follow the general rule of “buy at 9%, sell at 3%”, you set yourself up for success based on historical behavior.

Today, the high yield spread sits right at the bottom of that range at 3.37%. In fact, that number just rebounded off of that 3% mark it hit back at the end of June of this year.

The story here is that history suggests there just isn’t a lot of share price upside left. The SPDR Bloomberg Barclays High Yield Bond ETF (JNK), which is meant to cover the entire junk bond market, has an effective duration of 3.6 years right now. That means that even if interest rates were to drop a full 100 basis points, JNK’s share price could be expected to rise by around 3.6%. Add that number on to a current yield of about 3.7% and you’ve got a total return potential of just over 7% in even the most bullish of bond market scenarios.

The opposite, of course, also holds true in the event of a spike in interest rates.

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Courtesy Of Michael Gayed - Lead-Lag Publishing LLC, USA