Mark Hulbert: The surprising message of the junk bond spread

by | Jan 23, 2023 | Stock Market

The U.S. economy is in relatively good shape—perhaps even stronger than average. That’s the surprising message of an indicator with an enviable record of anticipating recessions: The interest-rate spread between high-yield (aka junk) bonds and Treasurys. Since high yield/junk bonds are those most vulnerable to default in the event of an economic downturn, it makes sense that the yield spread between them and Treasurys would widen considerably as the economy weakens and eventually turns down. The spread’s track record since the late 1990s is plotted in the accompanying chart.

Currently, however, as you will also notice from the chart, junk bond investors are not demanding the higher premium that historical precedents suggest they would if a recession were imminent. In fact, the current premium, as measured by the ICE BofA US High Yield Index Option-Adjusted Spread, is below average. It’s difficult to square the spread’s relatively-upbeat message with the Wall Street consensus that a U.S. recession is nearly certain to begin in 2023—if it has not already begun. Last Fall, for example, the Conference Board, which compiles and publishes the Index of Leading Economic Indicators, put the odds of a U.S. recession by the end of 2023 at nearly 100%. Either this pessimistic Wall Street consensus is right and the high yield spread is wrong, or vice versa. Which is it? Verdad, the Boston-based investment firm, recently approached this question by researching the possibility that the high yield spread is sending a false signal. Conducted by Greg Obenshain, the firm’s Director of Credit, his study is titled “Inside the High-Yield Spread.” Specifically, Obenshain explored whether the high-yield spread’s current below-average level is being caused by an increase in the credit quality of the average junk bond. Over the last decade, Verdad’s data shows, a steadily increasing share of the junk bond market has been rated “BB” (the highest credit quality within the junk category), while the share of the market represented by junkier bonds rated “CCC” or below has steadily declined. Since “BB” bonds ca …

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