How are you bearing up?
We are living history here – aren’t we? It’s crazy and unprecedented. I’m sure like me you’re stuck at home and trying to work. But there have been some bright spots – my wife and daughter running a Girl Scouts meeting on Zoom! That was funny when all the girls disappeared and came back with their pets to show everyone!
But inbetween the fun I’ve been stressing about the stock market.
But you don’t want more stress – right? You want solutions. So let’s dig into an idea I have been investigating.
The bond market
We’ve all been pre-programmed to believe that stocks will provide us with long term returns. It’s been a corner-stone of the FIRE movement. Historically it’s true – even though we’ve been sorely tested through the recent crisis. But don’t discount bonds!
A couple of weeks ago I wrote about the long Treasury bond market (aka STRIPs) and how that has been a rich source of opportunity. But the thing about the bond market is that it is very wide and deep – so let’s dive into another area!
High yield bonds
One way to think about investments is along a continuum of risk. You have stocks at one end – being the most risky – and bonds at the other. However the bond universe is extremely diverse with further sub-divisions. Treasury bonds are the safest, and would be at the opposite end to stocks. The next safest bonds are “investment grade” bonds. This is debt issued by the safest companies in the world. If you want to lend money to Microsoft then you would be buying an investment grade bond.
Next comes sub-investment grade bonds or “high yield” bonds, or “junk bonds”. High yield bonds are mostly corporate debt issued by companies that are rated as having less security. An example high yield name is currently Sprint.
In general high yield bonds are safer than their equivalent stock. So you should expect a lower return and lower risk from Sprint bonds compared to Sprint stock.
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I’ve never been a great fan of high yield bonds. Historically they don’t give the high returns you expect from stocks but also don’t benefit from the diversifying impact of bonds. When things crap-out high yield bonds can’t be relied upon to cushion your stocks.
And that’s pretty much what has happened recently. The high yield index has lost about 20% YTD. That’s less than stocks but it’s not the great diversifier we want to see from bonds. Treasuries behave much better in a crisis.
See below for a comparison of high yield and stocks. It ain’t zigging when stocks are zagging!
So why consider this now?
High yield has sold off. The price has plunged and I’m trying to assess whether now is a good time to buy.
There is no way I would try and call the bottom of the stock market, so why do I consider myself supremely gifted as the bond whisperer?
Bonds are different to stocks. They provide a certain (nominal) return provided the issuer does not default. And that is key at the current time. if you buy a high yield bond for a relatively cheap price now and the bond does not default then you have a very nice yield. In fact yields are running at around 11.5% which is historically high – see below.
Yields are not as high as during the financial crisis but that is because interest rates are now much lower.
Verdad capital did some analysis of historical bounce-back returns in different past crises and high yield can be attractive in the years following a crisis – see below from their article.
To further explore the potential we need to look at a new concept that will help us assess the implied default rate of high yield – the credit spread.
Why invest in high yield as opposed to Treasury bonds? The only reason you might is if you expected a reward – or risk premium. This is the excess yield you can get over a similar Treasury bond and is called the spread. The spread is the excess yield over Treasury bonds, and rewards the investor for taking additional default risk.
So how does the spread look at the moment? Ummm, high…
High yield spreads have recently gone through the roof to almost 10.1% (or 1,100 bps). That’s really high and can be seen in historical context in the chart above. As a guide a spread over 1,000 is considered “distressed” in the bond world. So we have the entire high yield index in distressed territory.
As a reminder this is saying that investors are so concerned with corporate defaults that they are demanding a return of over 10% a year in preference to simply holding Treasury bonds. That’s a pretty big insurance premium.
At this point you might be wondering two things:
- Wow that spread is pretty wide – investors are panicking about the future and the impact a recession could have on corporate America – I had better steer clear of this.
Or you might be thinking:
- The market always over-reacts and there has been a huge rush for liquidity and selling which would have pushed prices down. I wonder whether this spread level implies a default level that could be justified even in a bad recession?
It’s this second point that we will explore some more.
There is a simple formula to get from the credit spread to an implied default level. Your expected loss from a bond is the default probability multiplied by your loss, and your loss is one minus the recovery rate.
In a default situation it’s common for the bond-holders to at least get some of their money back. They might not recover 100 cents on the dollar, but historical recovery rates have been around 30-50%. The chart below shows historical recovery rates.
Historical default rates have been volatile but the period after the Global Financial Crisis has been around 3%. See the following chart.
Allowing for illiquidity
But over this period spreads have been much higher than 180bps and actually been 400-500bps.
So either investors have been demanding too large a spread to compensate for the defaults, or they have been over-estimating defaults. The reality may have been a mixture, but the spread only partially compensates for defaults, it also compensates the investor for the limited liquidity and marketability of the high yield bond. If you are going to hold a Sprint bond in preference to a Treasury bond then you will want to rewarded for the limited market you will find for Sprint bonds compared to the almost unlimited market for Treasury bonds.
In my research I couldn’t find a consensus estimate for illiquidity premium, but I saw 300bps cited a few times.
In our example above the spread attributable to default is 180bps and the spread attributable to liquidity is around 220-320bps, giving a total spread of 400-500bps.
What do current spreads tell us about default rates?
Currently spreads have spiked to around 1,100bps. But what does that tell us about investor’s expectations about future defaults? Let’s assume a recovery rate of 40% and assume an illiquidity premium of 300bps. We then get:
- Spread 1,100bps
- Less illiquidy premium 300bps
- Resulting spread (attributable to defaults) 800bps (or 8%)
- Assuming a recovery rate of 40% then implied default rate is 13.3% [ 8% / (1-40%) = 13.3% ]
That’s pretty high and approaching the levels of the financial crisis where defaults were around 14% for a period.
But there is considerable uncertainty around these assumptions. Let’s look at some different scenarios.
Our example above considered an illiquidity premium of 300bps and a recovery rate of 40%. In the table above it you trace up from 40% and across from 300bps you get the implied default of 13.3%. You can see the implied default rate is pretty sensitive to the assumptions. Given the illiquidity premium is essentially unknown (or unknowable) and the recovery rate is difficult to assess our analysis is somewhat of a crapshoot.
The question you have to ask yourself is – Is the market over-estimating these future defaults? If you believe that the market is over-reacting and the $2Tn stimulus package will help stem the tide of future defaults then perhaps spreads have gone too high and don’t reflect future defaults and the price is a buy.
Or alternatively you may think the worst is yet to come and default rates could be even higher, in which case spreads may not adequately compensate you for the current environment, and 1,100bps spreads may be too low!
What do you think? Is this an asset class you’ve ever invested in? Do you think current spreads are under-stating or over-stating future default levels? Comment below and let me know.
Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post.