Sanford and Son: Bonds Hit a Rough Patch

Furgeson Wellman by Brad Houle, CFA Executive Vice President

Sanford and Son was a TV series in the 1970s about a disagreeable junk dealer and his adult son. In one reoccurring gag in the series the main character, Fred Sanford, would dramatically grab his chest and exclaim, "Oooo….It’s the big one….You hear that, Elizabeth… I'm comin' to you."  This simulated heart attack was perpetrated by the Fred Sanford character to make his point when exasperated and was always a false alarm. Recently, the junk bond market hit a rough patch with investors exiting junk bond funds, causing bond prices to decline. The question at hand is, is this correction "the Big One," meaning a new credit crisis, or simply a minor correction akin to the dramatic fake heart attack that Fred Sanford used to torture the other characters on the show?

Bonds that are below investment grade are often referred to as junk bonds due to the lower credit quality of the companies issuing the bonds. Junk bond is somewhat of a pejorative description of an important part of the bond market. Small companies that are growing, which is a large engine for the U.S. economy, often fit into the category of below investment grade credit. It is important that there are public market debt financing options available for these entities. Because of the lower credit quality, investors demand more compensation in the form of interest in order to loan these companies money. Also due to the lower credit quality, there is a higher potential default risk for these bonds.

Recently, there has been an outflow of money from high yield bond funds as investors have become nervous about the risks of below investment grade bonds. With interest rates being so low for an extended period of time, the hunt for yield by investors has been intense. Money has been flowing into the type of investments that can offer a higher income than the traditional bond market. Below investment grade bonds have been one of the asset classes that has benefitted from this cash flow. As a result, the prices of high yield bonds have been bid up and the resulting yields are down because they move inversely to one another.

The higher the risk in a bond, the higher the yield should be to compensate for the risk. The way risk is measured in high yield bonds is the yield spread over U.S. Treasury bonds. Bonds issued with the full faith and credit of the U.S. Government are considered to be riskless with respect to default. High yield bonds can default and, as a result, investors receive additional interest over a treasury bond to compensate for that risk. For example, if a U.S. 10-year Treasury bond is yielding 3 percent, a high yield bond should yield 8 percent, given the historical relationship. Traditionally, the average spread between high yield bonds and U.S. Treasury bonds is 5 percent. With the insatiable demand for income, high yield bond prices have risen to a point where investors are only getting 3 percent more interest than treasury bonds.

Our view is that this is a normal correction that has more to do with the recent stock market volatility than credit quality. The high yield market is often more closely correlated with the stock market as opposed to the bond market.  On average, the underlying credit quality of high yield bonds is better than average as evidenced by the default rate. According to Standard & Poor’s, the default rate on high yield bonds has recently been around 2 percent, well below the long-term average of just over 4 percent.

With the strong demand for high yield bonds, the valuation probably did get extended; however, we don't believe this is the start of another credit crisis.

Our Takeaway for the Week

  • Geopolitical events continue to drive equity and bond market volatility