Speculative-grade debt offers an attractive buying opportunity for investors as relative yields on the securities are elevated, according to Martin Fridson, global credit strategist at BNP Paribas Investment Partners.
The extra yield that investors demand to hold high-yield, high-risk bonds compared with Treasuries was 108 basis points wider than their fair value of 532 basis points as of July 5, according to the Fridson-Kong model. The divergence often accompanies an increase in the VIX Index, a measure of stock- market volatility, Fridson’s models show. The deviation from the fair value has remained even as the VIX recorded its biggest monthly decline this year in June.
“If high-yield bonds are below fair value because of general upheaval it doesn’t look like a great bargain,” Fridson said in a telephone interview. “But here, not only are they cheap relative to fair value, we are also not seeing a lot of volatility in equity markets.”
The VIX Index (VIX), also seen as a measure of unease in financial markets, has declined from a 2012 high of 26.7 on June 1 to 17.5 on July 5, about the lowest level in two months. Relative yields on junk-rated bonds are 48 basis points wider than the 592 basis points reached on May 3. Junk bonds are rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s.
In the first half of 2011 the spread on high-yield bonds was 11 basis points wider than fair value when the VIX averaged 17 on a monthly basis. Later in the year, when euro-zone turmoil flared and S&P downgraded the U.S. credit rating, the gap in actual spread and fair value climbed to an average of 260 basis points, as the VIX monthly average rose to 30 for the second half of 2011, Fridson’s research shows.
In May, speculative-grade bonds were undervalued and the VIX surged as concern that the European debt crisis would infect the global economy mounted. The VIX has since retreated below its monthly average of 18 in the first four months of 2012 as European leaders took steps to stem the crisis. The divergence of high-yield spreads from their fair value has not recorded a similar decline.
“One possible interpretation is that the equity market has overreacted to the positive developments in Europe and that high yield has shown greater skepticism,” Fridson said. “But junk bonds are fundamentally cheap, and if you have a longer-term horizon there is possibility to make good money.”
The Fridson-Kong model, named after Martin Fridson and BNP Paribas analyst Vince Kong, takes into account data on industrial production, capacity utilization, the default rate, credit availability and the 5-year Treasury yield to determine the right value of junk debt.
Speculative grade bonds in the U.S. have returned 7.6 percent this year, according to the Bank of America Merrill Lynch U.S. High Yield Master II index, compared with a 5.5 percent return on investment-grade debt. The Standard & Poor’s 500 has returned 10 percent with gross dividends reinvested into the index.
“To justify their current valuation, there has to be something going on that directly affects the high-yield market and not any other asset class,” Fridson said. “There is nothing going on in this space that can explain this.”
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