Stocks fell today, with the S&P 500 (SNPINDEX: ^GSPC ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI ) losing 0.1% and 0.2%, respectively. The VIX (VOLATILITYINDICES: ^VIX ) , Wall Street's fear gauge, dropped 0.6% to close just below 13. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)
What happened to the "high" in "high yield"?
On Friday, the yield spread on the Merrill Lynch B of A Master II Index, one of the best known junk bond indexes, closed at 5.08%; the spread is the additional yield investors require to hold junk bonds rather than equivalent maturity Treasury bonds. That figure is simply inadequate -- in December, veteran high-yield bond analyst Martin Fridson estimated its fair value at 6.82 percentage points.
Since 2008, the yield spread has dipped below 5 percentage points during two periods: a four-month period beginning at the end of January 2011 and a 16-trading-day stretch that began last month. That's not a good omen for investors -- whether in junk bonds or stocks. Here's how both asset classes performed, on a price basis, over the three months that followed the former period:
^SPX data by YCharts.
This is not just a technical "spot the pattern" matter -- my concern is driven by careful consideration of value. At the end of last month, Dan Fuss, the vice chairman of Loomis Sayles, whose Loomis Sayles Bond Fund has beaten 98% of its peers over the past three years, told Bloomberg News: "High-yield is as overbought as I have ever seen it; this is absolutely, from a valuation point, ridiculous."
Dan Fuss has been in the business for 55 years. In May 2007, his fund was the best-performing in its category over the prior 10 years, but that success hadn't made him complacent. Instead, he told Bloomberg News at the time, "I haven't felt this nervous about a market ever," in reference to junk bonds. No one need elaborate on what happened over the next 18 months.
Fridson has the same message as Fuss; in mid-December, he wrote:
"The high-yield market is extremely overvalued, by our analysis. Based on the consensus forecast of a rise in Treasury yields, the expected 2013 total return on high-yield bonds is below 0%."
In selling the iShares iBoxx High Yield Corporate Bond Fund ETF (NYSEMKT: HYG ) from my model portfolio at the end of last August, I may have been a bit early, but I am quite comfortable with that. (It's not a real-money portfolio, after all.) Investors who joined the rush into high-yield bonds via products such as HYG or the SPDR Barclays High Yield Bond ETF (NYSEMKT: JNK ) should consider the risk-reward trade-off they now offer -- before it's too late.
If you're looking for some long-term investing ideas, let me invite you to read the Fool's brand-new special report: "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so just click here and get your copy today.