What Is The High Yield Corporate Bond Market Telling Us?

I've spent a good amount of time looking at high yield corporate bond funds and their holdings; most of their charts look like Vanguard's VWEHX shown above: the majority of the year's price declines have occurred just since September.

Clearly, the high yield bond market is pricing in a high probability of defaults. According to a recent Financial Post article, default rates among high yield bonds through September has been 3.2%. During the last recession, in 2002, the default rate exceeded 16%. The iTraxx Crossover index, which reflects the cost of insuring against high yield defaults, hit new price highs last week, according to Financial Post. This insurance has become so expensive that two-thirds of all bonds in the index would have to default with a 40% recovery rate in order for the insurance purchaser to break even.

Have bond markets overshot the downside? Fitch Ratings is predicting the worst period of high-yield bond defaults ever, noting that fully 24% of the U.S. high-yield market is now accorded "junk" ratings and is at risk of default. Even these ratings may well understate the vulnerability of the high-yield market, however, as investors fear a repeat of overoptimistic ratings of subprime mortgage debt. Some will see the current high yields of oversold bond funds as a low-risk buying opportunity; others will see this as a harbinger of bad things to come in 2009 and 2010.

I find that the best time for longer-term investment is when bad news is coming out and markets are no longer making new lows on the news: the worst has been priced in. At this juncture in the high-yield market, the worst of the news hasn't even come out and we're in the midst of a price waterfall. At some point, this bond sector will be a great buy; I'll wait for the headline defaults--and an opportunity to gauge the reactions of stock and bond markets--before venturing into the business of catching falling sharp utensils.

RELATED POST:

Corporate Bond Price Performance
.