By failing to account for either the present level of credit risk or the change over time in the index’s composition, adherents of the historical average method will conclude that the high-yield bond category is currently drastically overvalued.
But when using a fair value model that takes into account credit availability, economic conditions, and Treasury yields, you get a dramatically different message.
After taking all of these factors into account, my analysis puts the fair value spread of today’s high-yield market at 2.66 percentage points. That is to say, the high-yield index – with its current OAS of 2.69 percentage points – is currently priced roughly where it should be – or, to be more precise, a bit wider than my model estimates. That means you’re actually earning more yield, on average, than the risk level necessitates.
Let me hasten to add that the spread should get a great deal wider once the next recession approaches. In that environment, credit conditions should tighten, economic indicators should weaken, and Treasury yields should decline. Based on historical norms, the high-yield spread could increase to 10 percentage points – or even higher.
That would obviously put the index’s yield far above the current 6.97%, producing a deeply negative total return on high-yield bonds.
Does that mean investors should avoid high-yield bonds if they think a recession is coming? Not necessarily.
Investment-grade bonds, rated BBB or higher, also typically go into the red during recessions.
Even Treasury bonds, as measured by the ICE BofA US Treasury Index, have inflicted negative returns on investors in 37% of quarters from 1997 onward, though this was not usually when there was a recession but during periods when interest rates were rising.
Of course, you could have completely avoided interim losses by owning only three-month Treasury bills. From 1997 through 2025, those super-steady instruments produced a 2.32% annualized return. But given that this is less than the period’s 2.66% average inflation rate, you would have been in the red on a real basis.
Most investors would probably prefer the 1997-2025 average annual returns of 3.84% on Treasuries, 5.10% on investment-grade corporates, and 6.45% on high-yield bonds.
“Junk bonds” will assuredly have their share of down quarters. But that’s no reason to avoid them entirely, especially at times when they appear to offer fair value for the risk.
HYG•
