In one sense, tighter spreads are justified. US corporate balance sheets look pristine, with S&P 500 companies sitting on more than $2 trillion in cash. That’s equivalent to more than 7% of their market cap, the highest ratio since the early 1960s. As a result, default rates are only around 2%, which is half of their long-term average.
Yet investors still need to be cautious. Spreads at this level appear rich not only relative to their historical average, but also particularly in the context of our current sub-par growth. High yield is the most economically sensitive of all the fixed-income segments. With economic growth stuck in the 2% vicinity, spreads would typically be closer to 600 basis points over Treasuries, as opposed to the current level of under 500 basis points. [Is It Time to Scale Back on High-Yield ETFs?]
And this all assumes the US is able to avoid the fiscal cliff and a recession 2013. While investors are starting to factor the fiscal cliff into their equity decisions, it is not clear that they are doing the same for the fixed income portion of their portfolio. If a trip over the fiscal cliff puts the United States back into a recession, then high yield would likely disproportionately suffer compared with other fixed income asset classes.
This is not to say that further spread tightening is impossible. Improving conditions in Europe, a favorable resolution to the US fiscal cliff (along with a willingness to address longer-term structural budget issues) and a steadily improving economy could all help to lower risk premiums, bolster corporate credit profiles and allow for further spread tightening. In fact, spreads have been considerably tighter in both the mid-1990s and the mid-2000s. But those environments were characterized by much faster growth and less systemic risk. The problem today is that it seems unlikely we will return to those conditions anytime soon.
Longer-term I still like high yield as an efficient way to generate potential yield with a reasonable amount of volatility. In addition, for more aggressive yield-focused investors – which we’ll define as those with a target yield of 4% to 5% – there are simply few alternatives. For the rest, and particularly for more tactically minded investors, this is probably an opportune time to reexamine your high yield exposure.
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.