As of March 23, 2023, the spreads on junk bonds over treasuries are 5.10%, or 0.1 standard deviations below the historical norm. When this spread is high it suggests that investors are very bearish about the future and demand a huge premium to invest in riskier securities like junk bonds. When the spread is very low, investors are bullish and willing to take on a lot of risk for relatively little return. The current spread suggests that market sentiment is Neutral.
Theory & Data
Junk bonds are bonds rated BBB or below and are considered non-investment grade, i.e., you shouldn't invest in them unless you're very comfortable with the prospect of losing that money. They have a reasonably high default risk, meaning that the issuer may be unable to repay the bond interest or principal on time, and so should command a commensurately higher return to compensate for that risk. This extra return is commonly referred to as the spread, which is the difference between the yield on the junk bond and the yield on a comparable US Treasury bond, which is considered to be risk-free as it is backed by the full faith and credit of the US government.
In additional to this risk premium, junk bonds also command higher returns due to a liquidity premium. Junk bonds are typically issued by smaller firms that may have limited access to capital markets. This means that these bonds may be less liquid compared to US Treasury bonds, which are widely traded and have deep and liquid markets. Investors should demand a higher return from junk bonds to compensate for the added risk of not being able to sell the bond quickly and at a fair price in case they need to exit their investment.
The below chart shows the recent history of junk bond rates compared to the 10 Year US Treasury bond.
The data source for junk bond yields is the ICE BofA US High Yield Index, an index that captures all BBB or below US domestic debt issuances greater than $100M. The Treasury bond data comes directly from the US Treasury. Since the junk bonds are not necessarily all at a 10-year maturity like the Treasury bonds, it's a bit inaccurate to compare the two series directly, as above. Instead, we can use the ICE BofA US High Yield Option-Adjusted Spread series, which calculates the spread between junk bonds versus an appropriately matched spot Treasury curve.
Current Values & Analysis
This chart is the actual rate spread for junk bonds since 1997, including a line showing the average spread over that period of 5.43%. Again, this means that on average, over the last ~25 years investors have typically demanded a 5.43% return over Treasuries to invest in riskier junk bonds.
Why The Volatility?
Theoretically, if you were to assume that the aggregate credit risk and liquidity of junk bonds were stable over time, then the spread between junk bond rates and Treasuries would be stable over time as well. As interest rates rose and fell, the rates of junk bonds and Treasuries would rise and fall as well, and the spread between the two would be more or less the same. So why isn't this the case?
There are a few reasons that can drive the volatility in this spread. The first explanation for the changing spread is simply that investors' risk appetite changes over time. During a bullish rally when the market is doing really well, investors begin to get more comfortable taking on risk. More and more investors will decide that they don't mind owning riskier assets, possibly because they fear on missing out on the greater returns that they see other investors getting, or maybe also because it has simply been so long since a default that they begin to think it just won't happen. Likewise, during a market crash like in 2008, investors get scared and 'run to quality', afraid to invest in anything that is seen as risky, regardless of the risk premium. In these periods that spread between junk bonds and Treasuries can rise dramatically.
The second reason these spreads change is more structural. Many institutional money managers need to achieve a certain return % every year (e.g., pension funds) in order to maintain payout or compliance ratios. During periods of very low interest rates, it may be very difficult to achieve those returns using only securities like US government agency or AAA rated corporate bonds. This forces these large funds to go further out on the credit curve and invest in junk bonds in order to get the returns they need. This increased demand in junk bonds will lower the yield on them, and therefore compress the spread between junk bonds and Treasury bonds.
Standard Deviations & Rankings
The last step is to show the same data but with bands showing standard deviations from the trend. As discussed above, high junk bond yield spreads are consistent with bearish markets, since that is when investors are avoiding risky assets. Lower yield spreads imply bullish markets as investors are more comfortable taking on credit and liquidity risk for smaller commensurate returns. Consistent with other models, any data values within 1 standard deviation of the historical average is considered a neutral market.
The current spread between junk bonds and US Treasuries is 5.10%, which is -0.1 standard deviations below the mean of 5.43%, indicating that market sentiment is currently Neutral.
Data sources used to create the models: