Confident or Irrational?

The WSJ has published an article today titled, “Corporate Bond Gauge Signals Dwindling Economic Risk”, in which they speculate that the narrowing of spreads for non-investment grade bonds (High Yield) relative to Treasuries reveals confidence in the economy’s rebound. But does it really?

“The average extra yield, or spread, investors demand to hold speculative-grade corporate bonds over U.S. Treasuries dropped below 3 percentage points this month to as low as 2.90 percentage points for the first time since 2007, when it set a record of 2.33 percentage points, according to Bloomberg Barclays data” (WSJ). As we mentioned the other day in our post, Private Pension Alert: Lock it in! Any reference to an event last accomplished in 2007 sends shivers down my spine.

I would say that there are a number of factors leading to this trend, including the need for yield in a low-interest-rate environment among retirees/pension plans. I would suggest that a spread this narrow signifies a market that has gotten ahead of itself from a fundamental perspective. Again, we are discussing non-investment grade bonds in this case. They are rated this way for a reason. Despite the fact that there has been a decline in the default rates recently, we live in an ever-changing landscape. According to S&P, “even though we expect very low funding costs through 2021, higher leverage and a large share of vulnerable corporates are likely to induce further defaults, resulting in the 12-month speculative-grade default rate rising to around 9% in the U.S.” Do you really want so little relative yield to navigate through such a challenging environment as the one described by S&P? I certainly don’t.

Again, we would suggest that one use investment grade fixed income for its cash flows and defease pension liabilities chronologically for the next 10 years. Don’t chase yield in when you aren’t getting paid to do so. This strategy will provide a longer investing horizon for the balance of your assets that will now have time to work through the uncertainties brought about by the global pandemic. 2007 may have started off on a strong footing, but we certainly know how it ended. Let’s not repeat the mistakes of the past.

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