The high-yield corporate bond spread is an important stock market indicator. The larger the spread, the greater the concern high-yield corporate bond investors have about the stock market and vice versa.
The high-yield corporate bond spread is the difference between the yield of the bonds issued by riskier companies and risk-free Treasury yields. The spread increases if there is a greater concern such companies may not be able to pay back 100% of the principal or at least not on time.
High-Yield Corporate Bond Spread Example
Below is a chart that shows how the average high-yield corporate bond spread is still only about 5% as of 4Q 2022, which is the historical long-term average. Only when the high-yield corporate bond spread is over 7.5% have there been recessions.
In other words, high-yield bond investors are “only” requiring about a 9.1% yield, or 5% greater than the risk-free rate of return of ~4.1%. The risk-free rate is the 10-year Treasury bond yield.
It's only when the spread rises to about 7.5% (11.6% high-yield versus 4.1% risk-free, which is always changing) is there a greater chance of doom.
A large spread means high-yield corporate investors believe corporations have a higher chance of defaulting or missing payments. These things happen mainly during times of economic stress.
Today, high-yield corporate bond investors still feel relatively comfortable about the future. They are only demanding an average 5% greater return than the risk-free rate. But the high-yield corporate bond spread is always changing.
Related post: How To Buy Treasury Bonds And Buying Strategies To Consider
Example Of A High-Yield Corporate Bond
Below is a Carvana (CVNA) bond. It has a coupon rate of 10.25% and a maturity date of 5/1/2030. The last trade yield is an impressive 22.428%, which you will get IF Carvana doesn't default for one year.
Although the bond is callable by the company, let's say the company keeps the bond available until the maturity date of 5/1/2030. A Carvana bond investor could buy the bond at its current price of 56.69 cents on the dollar, earn a 10.25% annual coupon rate for five years, and then get 100 cents on the dollar upon maturity.
Not bad! But are you willing to take the risk? There's a reason why the company's stock price is down 95% since August 2021. Further, if Carvana survives, will it be foolish enough to keep paying such a high coupon payment if inflation and interest rates decline aggressively before the maturity date? Doubtful.
I hope this example better helps explain the concept of looking at high-yield bond spreads over the risk-free rate of return. In this example, the spread is about 6.15% (10.25% – 4.1% for the 10-year bond yield today). Then you've got to add back the potential of being paid back fully at maturity.
Example Of Needing A Lower Risk Premium (Spread)
As an investor in risk assets, we require a return above the risk-free rate of return to compensate us. The greater the spread, the greater the perceived risk of investing in such an asset class.
On the flip side, the lower the spread, the lower the perceived risk. The more financially sound the borrower, the lower its borrowing cost.
Let's say Harvard University issued a 5-year bond at 5%, only 0.9% above the current 10-year bond yield. Such a small spread might be attractive enough because you know there's an insatiable appetite for families to pay exorbitant tuition rates due to hope, status, and prestige.
If a billionaire like Elon Musk wanted to borrow money as a bridge loan, a lender would probably not need as high of a risk premium (spread). If the risk-free rate is 4.5%, the lender might even lend at parity to try and win more business from Elon in the future.
Related post: The Allure Of Zero Coupon Municipal Bonds
Happy With Your Wealth Means Lower Spread Needed
This bond yield spread concept also pertains to your personal financial needs. If you are happy with the wealth you've already built, you won't require a large spread. The same goes for if you've conquered greed by giving up your maximum money potential. You're more satisfied investing in lower-risk assets.
Personally, I'm happy with how much passive income my portfolio is generating now. Thanks to a bear market, it's easier to generate more passive income. I estimate our 2023 passive income will increase by 10%.
Given we live off less than $250,000 gross, there is no need to take excessive risk. Buying Treasury bonds yielding 4.5% and investing in real estate crowdfunding for hopefully 7% – 10% passive returns is what I favor.
Our main goal with two young children is to stay retired. We want to spend as much time with our children as possible before they both go to school full time. The worst thing that could happen is if we invest in risky assets that plummet and cause us to return to work.
Yield Spread Is Relevant For Your Safe Withdrawal Rate In Retirement
The yield spread concept also pertains to understanding the proper safe withdrawal rate in retirement. Instead of following a fixed withdrawal rate, I recommend following a dynamic withdrawal rate. Be adaptable with the changing times!
I have a feeling one of the reasons why so many people have bashed me over the head about my dynamic FS Safe Withdrawal Rate Formula is because they don't understand how everything revolves around the risk-free rate of return.
But just like how we no longer burn witches at the stake, with more education, we slowly stop vilifying people and things we don't understand. The vilification of others is also why some people prefer to stay quiet or agree with everything someone says, despite knowing a better solution.
The higher the risk-free rate, the higher your safe withdrawal rate in retirement and vice versa. It makes sense to be able to increase your safe withdrawal rate when the risk-free rate increases because you can earn more passive income in a bear market.
Never Stop Learning
Whether we're talking about the significance of the high-yield corporate bond spread for stocks or figuring out the appropriate asset allocation, never stop learning.
Always remember the importance of the risk-free rate of return. All risk assets are priced off of it.
If you want an easy financial reference that puts you ahead of probably 95% of the population, read my book, Buy This, Not That. It is an instant Wall Street Journal bestseller. I go deep into the most important topics you should all know about.
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Fixed income has never been my strong suit, so I learned a lot in this article – thank you! I’ve never invested in corporate bonds, but I will pay attention to the high yield corp bond spread from now on. It’s so cool to learn new things. Which brings me to the other thing I wanted to say – I love how you ended on the importance of always continuing to learn new things. It definitely keeps life way more interesting for starters. And it can be so enriching. thanks!