Mispriced Junk

August 14, 2017

One of the most important concepts for an investor is known as “spread.” The logic behind it is pretty straightforward. If I can buy something with very little risk (like a US Treasury) and it earns me 2% a year for 5 years, then if I buy something riskier (like a leveraged company bond), I should earn a greater percentage over that same 5 year period. The difference between the two rates is what is known as the spread.

 

What happens over time is that the average spread fluctuates between different investments. One type of spread that is always worth keeping an eye on is the average spread between a US Treasury and a High Yield/Junk bond. Junk bonds are companies who are rated BB or below and are considered at risk to make their debt payments. Junk bonds always pay a positive spread to treasuries which makes sense because they are riskier and you want to earn more to take that risk. However how much more you earn is always in flux.

 

Lately that spread has become tighter as illustrated by the chart above. There can be a few interpretations of what this means. Some might argue that the economy is doing well and that even though junk bonds are riskier, investors don’t need as much spread (additional returns) because companies are doing fine in this environment. This would be the more optimistic interpretation.

 

I however side with my colleagues at PIMCO and DoubleLine who we invest with. The tight spreads seem to indicate that investors are becoming complacent again about risk. As people reach for higher returns they neglect to understand how much more risk they are acquiring to do so. While the world is not in any type of dire situation, taking on significant increases in risk for smaller and smaller spreads is not the correct type of investment decision. Remember that junk bonds sold off nearly 25% or more during the financial crisis while US treasuries returned double digits instead.

 

Late cycle investing is always tricky and most investors end up playing a game of chicken. They are darting in and out of risky investments trying to squeeze out a few more dollars before getting caught. It is inevitable that most of them will get burned. Our advice is simple in these times, don’t reach. There will come a time again where valuations are better and risk will have greater rewards. We will continue to march forward earning a reasonable amount in this environment while keeping a tight grip on the amount of risk we deem acceptable to take. Over the long term we truly believe that the market rewards the diligent and patient.

 

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