The Junk Spread is another variation of an interest rate spread. This particular metric reveals the cumulative risk appetite of the particular market. This is so because as the yield on junk bonds converges with that of more sound issues, it shows that investors are interested more in yield than quality. A tightening in this department occurs when risk is pushed aside for return preferences. This is the case for today’s market and as the graph above shows, as a compliment to the 10-2 spread, it can give us some serious color.
It can be said that any time investors as a whole begin trading quality for a yield toward the lower end of this range, a sort of negligence becomes the rule of law. When others see the small improvements of their competitors on performance reporting day, they will likely want to keep up in the short-term, despite the risks of lowering standards. Going hand in hand with this metric, the average amount of covenants for bondholders is falling as investors tend to bid up fixed income securities, no matter the protections.
The worst part about this is that the bond bull market has been going on for about three decades. Because of this length, two generations of working investors have become used to it. Now that rates are so low, and rising, each incremental increase could prove troublesome. When, for decades, investors got rewarded for going out on the risk spectrum for a few basis points, they now have the opportunity to face the music. To counter this, many speculate that we are in a “lower for longer” period where, given time, we will adjust to this new normal and grow into higher rates when they come.
That is the hope, but most times when investors throw caution to the wind for marginal improvement in returns, the near future proves punishing.
Source: FRED St. Louis Fed, WSJ Daily Shot (9.14.17), Moody’s