Junk Bond Spreads
Overview
As of November 30, 2023, the spread on junk bonds over treasuries stands at 3.84%, or 0.6 standard deviations above the historical norm. A high spread suggests that investors are pessimistic about the short-term future, requiring a larger premium to invest in riskier assets like junk bonds. Conversely, a very low spread typically indicates that investors are optimistic and more willing to take on significant risk for relatively lower returns. The current spread suggests that market sentiment is Neutral.
Theory & Data
Junk bonds are bonds rated BBB or below, categorized as non-investment grade. These bonds carry a higher risk of default, meaning the issuer may struggle to repay interest or principal on time. As a result, investors demand a higher return, known as the spread, to compensate for this increased risk. The spread is the difference between the yield on a junk bond and that of a comparable US Treasury bond, which is considered virtually risk-free due to its backing by the US government’s full faith and credit.
In addition to the risk premium, junk bonds also carry a liquidity premium. These bonds are typically issued by smaller companies with limited access to capital markets, making them less liquid compared to US Treasury bonds, which are highly traded and have deep, liquid markets. As a result, investors demand higher returns from junk bonds to compensate for the added risk of potentially not being able to quickly sell the bond at a fair price if they need to exit their position.
The chart below shows the recent history of junk bond rates compared to the 10-year US Treasury bond. The data for junk bond yields is sourced from the ICE BofA US High Yield Index, which tracks all BBB or below US domestic debt issuances greater than $100M. Treasury bond data comes directly from the US Treasury. Since junk bonds often don't have a 10-year maturity like Treasury bonds, comparing the two series directly can be somewhat inaccurate. Instead, we use the ICE BofA US High Yield Option-Adjusted Spread series, which calculates the spread between junk bonds and an appropriately matched Treasury curve.
Current Values & Analysis
This chart displays the actual rate spread for junk bonds over Treasuries since 1997, with a line indicating the average spread of 5.40%. This means that, on average, investors have required a 5.40% return over Treasuries to invest in riskier junk bonds over the last ~25 years.
Why The Volatility?
Ideally, if the aggregate credit risk and liquidity of junk bonds remained stable, the spread between junk bond rates and Treasuries would also remain consistent. However, this isn't the case, and there are a few reasons for the volatility in this spread.
One explanation is that investors' risk appetite changes over time. During bull markets, when investor sentiment is positive, there is an increased willingness to take on risk. Investors may be motivated by the fear of missing out on greater returns, or they might believe that defaults are unlikely due to the absence of recent defaults. Conversely, in market crashes such as in 2008, investors "run to quality," avoiding risky assets regardless of the premium, causing the spread between junk bonds and Treasuries to increase.
A second factor influencing these spreads is structural. Many institutional investors, like pension funds, need to achieve specific return percentages. In periods of very low interest rates, it may be difficult for them to meet these targets with only safe investments like US government or AAA-rated corporate bonds. This compels these funds to take on more risk by purchasing junk bonds, thus increasing demand, which compresses the spread between junk bonds and Treasuries.
Standard Deviations & Rankings
In the chart below, the same data is displayed with bands showing standard deviations from the historical trend. As mentioned earlier, high junk bond yield spreads generally indicate bearish market sentiment, as investors avoid risky assets. Lower spreads suggest bullish conditions, as investors are more willing to take on credit and liquidity risks for smaller returns. Consistent with other models, values within 1 standard deviation of the historical average are considered indicative of a neutral market.
Additionally, the y-axis is reversed in this chart, so that higher chart values correspond with more aggressive market behavior, ensuring consistency with other market models.
