True Crime: The Case of the Disappearing Yield

High-yield no longer.

Alex Dumortier
Alex Dumortier, CFA
May 10, 2013 at 7:39PM

The S&P 500 (SNPINDEX:^GSPC), and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES:^DJI) both finished the week on all-time (nominal) highs. For the S&P 500, that makes six record highs in seven days. The impressive stock market rally hasn't left small-cap stocks behind, either; the Russell 2000 Index also achieved a record high on Friday.

Not surprisingly, then, the VIX Index (VOLATILITYINDICES:^VIX), Wall Street's fear gauge, fell 4% to close at 12.59, its lowest level since April 12. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

The incredible shrinking yield
While the sentiment data does not support this notion, the above statistics suggest that fear has been expunged from this market. Still, the most egregious examples of this phenomenon are not to be found in equities, but rather in fixed income. As the following graph demonstrates, junk bonds have put up equity-like returns since March 9, 2009, the date on which the stock market bottomed. The blue line (left axis) represents the BofA Merrill Lynch US High Yield Master II Total Return Index, and the red line (right axis) represents the S&P 500:

(Strictly speaking, this is not a like-for-like comparison, since the S&P 500 index does not here include dividends, but it's enough to show the similarity in returns.)

Those returns are largely the product of price appreciation. Bond prices are inversely related to yields and, this week, the yield on both major high-yield indexes, the BofA Merrill Lynch US High Yield Master II Index and the Barclays US High Yield Index, dipped below 5% for the first time ever. High yield? Methinks the asset class needs to be rechristened. The yield graph of the BofA Merrill Lynch US High Yield Master II Index tells a post-crisis tale of the incredible shrinking yield:

In late 2008 and early 2009, no one wanted to own high-yield bonds at yields of 20%-plus; today, everyone wants to own 'em at yields of 5% and below! Howard Marks, an expert distressed debt investor and chairman of money management firm Oaktree Capital, told Michael Milken at the Milken Institute Global Conference last week:

Most things, especially things involving people, are governed by cycles: The economy cycles constantly, the lifecycle of businesses, the markets are cyclical. And yet, repeatedly, people commit the mistake of thinking that trends will go on forever in one direction... and these are when the biggest errors are committed by investors.

Shareholders in the iShares iBoxx $High Yield Corporate Bond Fund (NYSEMKT:HYG) and the SPDR Barclays High Yield Bond ETF (NYSEMKT:JNK) ought to ponder those words and ask themselves: Which is more likely, that yields continue to go down forever, or that we are at or very near the bottom of the cycle?