High Yield Bond Market Bets On A Sickly Goldilocks

An article by New York Institute of Finance instructor Doug Carroll.

A reasonable inference from current valuations in the U.S. high yield corporate bond market is that recent trends in growth and inflation are likely to continue for the foreseeable future. Specifically, GDP growth is likely to remain subdued and inflation to remain stable and low. If these trends hold, high yield bond rates would be relatively stable, thus earning a return close to the yields at which they are currently trading. Returns in the middle single digits would handily outperform the low single digit return on treasuries implied by that scenario.

Forecasting such an outcome entails an implicit view of Fed policy and its impact (or lack thereof) on the real economy: continuation of current Fed policy effectively maintaining high financial asset prices and low treasury rates.  Low treasury rates would mean that Fed policy had failed to ignite growth.  In other words, it would be an economy that is neither too hot (so as to require Fed tightening resulting in higher rates/rising bond yields and capital losses), nor one that is too cold (no recession, thus avoiding wider credit spreads, higher bond yields and capital losses by a different route).  A Goldilocks environment for high yield bond investors!

But if Fed policy were to be considered a success by its own criteria, the real economy would have to achieve escape velocity, something like 3% real GDP growth.  Such an outcome would result in the Fed scaling back on its monetary easing, if not outright tightening.  In either of these cases, a rising rate environment leads to capital losses for bondholders.  For interest rates to stay flat, the Fed’s policy must be ineffectual at spurring growth, leaving us with suboptimal (by historic standards) 1-2% real GDP growth.  The sickly Goldilocks cited in the title!!

Unfortunately for high yield bond bulls, current trends are unlikely to continue for too long and neither of the two economic scenarios which are likely to arise would be constructive from the perspective of holders of longer duration high yield bonds.  Continued subpar growth with stable low inflation is likely to be supplanted by one of two probable economic states; either somewhat more robust growth (2.5-3.0%) if an economic recovery truly takes hold, or an economy that stumbles on one of the many economic or geopolitical challenges confronting it resulting in further erosion of growth, possibly tipping into a recession.  Either outcome implies rising high yield rates (albeit for different reasons), thus capital losses, on high yield bonds.

Most pundits seem to buy into the conventional wisdom regarding the economic forecast: continued (painfully) slow recovery of the economy, GDP growth rates gradually attaining a speed close to the economy’s potential for sustainable non inflationary growth.  Some would ascribe this result to the successful application of massive economic stimulus (fiscal and especially monetary).  Others would credit the inherent dynamism of markets managing to expand despite a host of growth inhibiting policies along with a mountain of uncertainty (tax, economic and regulatory).  In either case, the onset of something like normal GDP growth will result in the Fed tightening at least a little (even if only cutting back on its current easing).  The consequence would be higher treasury rates.  High yield bond prices would have to fall if their yields rise in tandem with the pick-up in treasury rates.

High yield sector bulls comfort themselves with the belief that any treasury rate rise would likely be negated by a contraction of the spread of high yield bonds versus treasuries.  Despite credit spreads currently at their post financial panic nadir (approximately 450 basis points), this view holds there is room for further narrowing as the economy improves, reducing concerns about credit risk in the sector.  As support for their argument, bulls cite several instances of this spread narrowing to less than 300 basis points in the 80’s and 90’s.  The bulls believe spread compression will offset the increase in treasury rates, leaving high yield bond rates essentially unchanged.

Undermining this argument is the fact that we live in a post great recession world, it may be that in the current environment of increased financial, economic and geopolitical risk credit spreads may not be able to narrow much further.  Additionally, the economic conditions that led to the spread narrowing to less than 300 basis points were very strong economic growth in a period of declining inflation, neither of which are conditions likely to obtain over the next few years.  So, even modest economic growth is likely to cause treasury rates to increase more than can be offset by any tightening of credit spreads, leading to higher rates and falling prices in the high yield market.  And that’s assuming no uptick of inflation.

Of course, the potential of rising inflation and the added increase in market interest rates further undercut the bullish case for high yield securities.  If rising inflation expectation coincides with a weakening real economy, the combination of rising treasury rates occurring simultaneously with widening credit spreads would be toxic for the high yield market.  This is the bull’s nightmare scenario and, I fear, is the most probable course for the economy to follow over the next year.

The economy is facing increasing headwinds, a confluence of higher taxes (e.g. repeal of the Bush era tax cuts and ACA-related levies among others), increased regulatory burdens/uncertainties (Affordable Care Act, Dodd-Frank, etc.) and slowing global growth (BRIC growth slowing, Europe sliding into recession).  Some would counter those factors with reference to positive developments domestically such as recovery in the housing and auto sectors. Yet these are growth stories dependent on continued low rates (along with reduced credit standards).  Increased inflation rates by themselves would undermine these weak reeds the bulls hope will underpin the recovery in the real economy.

If recent lackluster economic growth persists or falters, additional monetary policy measures will likely be undertaken.  Chairman Bernanke has been persistent in both word and action about a willingness to consider increased/additional policy steps if that’s what is required to get the real economy moving.   This despite the recent experience of ever increasing levels of monetary stimulus in the aftermath of the ’08 panic coinciding with declining annual rates of GDP growth since the first year of recovery.  Additional monetary policy actions will prove inadequate to increase domestic GDP growth amidst all the surrounding adversity.  But the flood of dollars created in the effort may be the spark that finally ignites the long feared return of rising prices.

If either of these scenarios ensue long duration high yield bondholders are likely to suffer negative returns over the next year or two.  If it’s the latter circumstance, a weakening economy with rising inflation expectations, those could be very large negative returns.  Rather than betting on Goldilocks, I’ll side with the bears. (Full disclosure: recently sold off all holdings in high yield bond ETFs.)

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