Market Insights

Bonds finished 2023 on a strong note, in need of a breather as 2024 commences. Yet the current environment may be signaling caution ahead, especially in the lower credit quality bonds.

Bond investors are considered the worrywarts of the investing field. This makes sense as bond investors are most concerned with a return of their capital. Hence, bond investors evaluate risks that may jeopardize principal repayment. Evaluating credit market dynamics may give portfolio strategists insight into what plagues bond investors as well as where markets may be heading.

Bond markets reveal most by evaluating the yield differences between different bond qualities, bond types and bond maturities. Yield differences are referred to as spread, typically the spread differential with Treasuries. Recently, high-yield bonds have hit a particularly interesting signpost.

High-yield bonds are referred to by various names, such as non-investment grade bonds or junk bonds. High-yield bonds are those bonds that are most susceptible to defaults. (For bond wonks, we’re talking about bonds rated BB or lower.) Evaluating high yield spreads (or yield differences with Treasury bonds) can give insight into the current environment as well as forward-looking investment prospects.

High yield spreads recently hit a low of 3.34%¹, the lower end of the usual range. Normally, tight spreads accompany low default risk. This bodes well for the current economic environment suggesting bond investors that dabble in the riskiest aspects of the bond market are not too worried about getting their money back. That’s the good thing. The bad thing is that nothing is static in the investment world.

Portfolio strategists have to make investment merit determinations. Strategists have to think about the forward period, not just the current environment. Accepting situational dynamics coupled with mean-reversion, the current narrow spreads suggest high-yield bond investing may be vulnerable going forward. Current spreads are far below the long-term average and approximate the level when spreads shoot up, detrimental to high-yield investing. To compound things, high-yield spreads tend to expand rapidly often not leaving enough time to react until it’s too late. To a strategist, high yield spreads are viewed as a contrary indicator at the extremes and tight narrow spreads do not boost strategists’ confidence.

Though all risks cannot be avoided, risk mitigation is an objective of a comprehensive portfolio design. Interestingly, the rising defaults don’t seem to be priced into the high-yield market at this point. As such, it is wise to minimize high-yield exposure.

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