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Are High-Yield Bonds in a Bubble?


The bubble crowd is going off the tracks by merely looking at yields in isolation.

MINYANVILLE ORIGINAL Income investors are now getting the very last message they want at a time when the hunt for yield is so frustrating because US government bonds pay so little, or nothing at all, after inflation.

Commentators are throwing around the dreaded "B word." As in, high-yield bonds are in a bubble. Yikes.

Getting a mere .7% yield on a 5-year US treasury bond is bad enough. But who wants to be the person who buys an asset class, high-yield bond, when it's in a bubble?

Well, calm down. The high-yield "bubble analysis" is incorrect because it's way too superficial, believes one bond fund manager who is well worth listening to since his fund has handily beat competitors for the past five years.

"I don't believe we are in a bubble," says Paul Ocenasek, who co-manages the Thrivent High Yield Fund (LBHYX). The fund has bested competitors by 1.37% per year over the past five years, according to Morningstar, by returning an annualized 8.4% per year.

The bubble crowd is going off the tracks by merely looking at yields in isolation, pointing out that the Barclays Capital High Yield Bond Index now pays a 6.8% yield, which is about as low as it's ever been. This means, in their view, that high-yield bond prices are so exceptionally high, and thus the yields so low, that they have to be in bubble territory.

But as with anything in the markets, context is key. And the context here shows that the 6.8% yield doesn't really prove that high-yield bonds are in bubble territory, reasons Ocenasek, whose Thrivent High Yield Fund has returned 10.7% to date, and currently yields 7%.
  • First, consider the high-yield spread over the yield on 10-year treasuries. At 5.7 percentage points, it is above the long-term average of 4.7 percentage points. In other words, it is not nearly as low as you would expect it to be in a high-yield "bubble." High-yield spreads over treasuries decline, signaling a possible bubble, whenever high-yield bonds are bid up relative to treasuries. That lowers returns on high-yield bonds and narrows the spread. But we don't see that now. And that 5.7 point spread is not even nearly as low the spread you see during high-yield bull markets. That spread was a mere 2.7 percentage points during the 2007 bull market in high yield.
  • Next, that spread to treasuries is actually pretty high, historically speaking, given the low default rates on high-yield bonds. The default rate is now at 2.5%, says Ocenasek, compared to a long-term median of around 4%. Given the historically low default rate, the high-yield spread over treasuries should be more like four percentage points, instead of the current 5.7, he says. "The spread is above its long-term average, and the default rate is below its long term average," says Ocenasek. In short, not the stuff that bubbles are made of.

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