High Yield Corporate Bonds - A Safe Short Term Play With High Return Potential? (part 2)

• The historical spread (i.e. the difference) between BAA-rated corporate bonds and safe 10 year Government Constant Maturity Treasuries (AAA-rated) is about 1.75-2.0% over the last 50 years.  Including the recent credit crisis, the historical average spread is about 1.92%.
• The BAA/10 year Treasury spread peaks during the onset of all previous recessions and drops during economic recovery phases usually back to historical levels of around 2%.  Generally, high yield corporate bonds appreciated dramatically during the economic recovery phase as the spread narrowed back to historical levels - indicating that corporate junk bonds were good investments during economic recovery periods.  Perhaps high yield corporat bonds are a good investment now since our economy is thought to be recovering?
• The BAA/Treasury spread is currently 3.51% (i.e. far above historical averages) indicating that there is further room for high-yield bonds to appreciate and for the spread to narrow back to historical levels. The spread has been consistently decreasing (at a rate of roughly 0.1%/week) since hitting a high of 6.12% in December as investor confidence is quickly returning to corporate high yield bonds.  This would indicate a potential for another four to six months of recovery in the high yield corporate bond market at this rate, assuming that the economy continues to demonstrate signs of life. Of course the economic recovery is never a straight line, so take my optimistic predictions with a grain of salt.

Chart below:

• Blue line is 10 year constant maturity treasuries (AAA)
• Red line is BAA-rated corporate bonds
• Green line is the spread between the two (i.e. the difference)

Notice how the spread peaks during the previous U.S. recessions (example - see 1983, 2001 etc.) and comes back to historical levels after the economy recovers.  This most recent recession saw the largest spread in the last 50 years (i.e. see how green line spikes in 2008/2009) as the credit crisis dramatically increased risk in the financial markets.  Notice how the spread is quickly narrowing as the economy turns a corner and the credit crisis was dealt with effectively.  The risk appetite for corporate high yield bonds appears to be returning, and investor money is coming back into this market. The more money flowing into high yield bonds the more these bonds will appreciate, therefore creating an investment opportunity.

(Continued)