Proceed with Caution in Hunt for High Yield

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ishares blog logo Proceed with Caution in Hunt for High YieldGiven high yield credit’s recent rally and surge of inflows, I’m now getting a lot of questions about whether or not the asset class still looks appealing.

While high yield provides an attractive pickup in yield and I’m maintaining my neutral view of the sector, I believe the easy money has probably already been made and the asset class no longer looks cheap. As such, over high yield, I prefer investment grade credit and municipals.

As high yield credit is highly correlated with equities, it’s hardly surprising that the asset class has rallied sharply since fall lows, taking part in the strong rebound in stocks and other risky assets. The iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA: HYG) is up more than 12% from its early October closing low. Past performance does not guarantee future results. For standardized performance, please click here. And of course, this surge in price has been accompanied by a surge in flows. Year to date, $6.5 billion has flowed into high yield exchange traded funds, with half going to HYG.

Following this rally, the yield to maturity for high yield is roughly 7% or nearly a 500 basis point premium to the 10-year Treasury. That’s close to fair value given the following analysis.

When you look at the historical spread between high yield and the 10 year-Treasury, spreads typically tighten as expectations for the economy improve. They widen when investors are worried about a recession and credit quality.  In the past, economic indicators have explained roughly 50% of the variation in where high yield spreads relative to Treasuries, testifying that the economic situation has been a key driver of spreads LQDhistorically.

A comparison of high yield spreads with leading indicators today suggests that high yield should be yielding roughly 500 bps more than the yield on the 10-year Treasury, fairly close to current levels.

To be sure, I don’t believe investors should avoid high yield. Investors in high yield are still picking up significant incremental yield, and given strong corporate balance sheets, I don’t expect any significant pickup in default rates. But as the asset class no longer appears as inexpensive as it was last fall, I wouldn’t advocate aggressively putting new money to work in high yield.

Instead, I prefer investment grade and high quality municipals. I hold overweight views of both asset classes, which still appear relatively cheap versus Treasuries. Take investment grade credit, which is a nice substitute for those looking to lower their exposure to Treasuries. While high yield spreads have contracted by 250 bps since last fall, spreads for investment grade credit have not come in nearly as much.

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