The views expressed here are those of the author, the publisher of Income Securities Investor

By Marty Fridson

NEW YORK, July 23 (Reuters) - Credit spreads on so-called “junk bonds” may appear slim compared to historical averages. But that says more about the analytical method being used than the fair value of these instruments.

As their more appropriate name – high-yield bonds – suggests, these speculative-grade bonds offer investors more current cash income than fixed income instruments with higher credit ratings. But they also have more downside potential during tough economic times because of the elevated default risk.

One number that debt managers consider when determining their high yield weighting is the average spread versus Treasuries. Simply stated, that’s the amount of extra yield investors receive for accepting the risk of speculative-grade bonds rather than the so-called risk-free asset.

From 1997-2025, the monthly average spread was 5.23 percentage points, based on the Option-Adjusted Spread (OAS) of the ICE BofA US High Yield Index. On July 21, the spread was roughly half that at 2.69 percentage points.

So does that mean high-yield spreads are too thin?

Let’s first consider the traditional analytical approach. As Investopedia – a decent source for conventional financial wisdom — notes, “The high-yield bond spread is most useful in a historical context, as investors want to know how wide the spread is today compared to the average spreads in the past. If the spread is too narrow today, many savvy investors will avoid buying into junk bonds.”

There’s a fundamental flaw in this reasoning, however. The high yield spread is a risk premium. If risk is higher than average at a given time, the risk premium should be greater than average as well. Determining whether high-yield bonds as a class are currently rich or cheap requires a comparison of the spread with the prevailing risk.

There’s one further problem with comparing the U.S. high-yield index’s spread with its historical average. Over time, the index’s composition has shifted to a lower risk profile.

Currently, the lowest-quality tier, with ratings of CCC or below, accounts for just 10% of the index’s total face value amount. Ten years ago, the comparable figure was 16%. Secured bonds, which provide a higher recovery rate in the event of default than unsecured bonds, have doubled over that period, from 18% to 37% of the total face value amount.

These changes don’t mean that, for example, the average BB unsecured bond is either riskier or less risky than in the past. But because of the dramatic improvement in the quality of bonds in the index, you’ll see a narrower average spread, based on a fair value analysis, than you did in earlier times, all else being equal.

FAIR VALUE

By failing to account for either the present level of credit risk or the change over time in the index’s composition, adherents of the historical average method will conclude that the high-yield bond category is currently drastically overvalued.

But when using a fair value model that takes into account credit availability, economic conditions, and Treasury yields, you get a dramatically different message.

After taking all of these factors into account, my analysis puts the fair value spread of today’s high-yield market at 2.66 percentage points. That is to say, the high-yield index – with its current OAS of 2.69 percentage points – is currently priced roughly where it should be – or, to be more precise, a bit wider than my model estimates. That means you’re actually earning more yield, on average, than the risk level necessitates.

FAIR WARNING

Let me hasten to add that the spread should get a great deal wider once the next recession approaches. In that environment, credit conditions should tighten, economic indicators should weaken, and Treasury yields should decline. Based on historical norms, the high-yield spread could increase to 10 percentage points – or even higher.

That would obviously put the index’s yield far above the current 6.97%, producing a deeply negative total return on high-yield bonds.

Does that mean investors should avoid high-yield bonds if they think a recession is coming? Not necessarily.

Investment-grade bonds, rated BBB or higher, also typically go into the red during recessions.

Even Treasury bonds, as measured by the ICE BofA US Treasury Index, have inflicted negative returns on investors in 37% of quarters from 1997 onward, though this was not usually when there was a recession but during periods when interest rates were rising.

Of course, you could have completely avoided interim losses by owning only three-month Treasury bills. From 1997 through 2025, those super-steady instruments produced a 2.32% annualized return. But given that this is less than the period’s 2.66% average inflation rate, you would have been in the red on a real basis.

Most investors would probably prefer the 1997-2025 average annual returns of 3.84% on Treasuries, 5.10% on investment-grade corporates, and 6.45% on high-yield bonds.

“Junk bonds” will assuredly have their share of down quarters. But that’s no reason to avoid them entirely, especially at times when they appear to offer fair value for the risk.

(The views expressed here are those of Marty Fridson, the publisher of Income Securities Investor. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and Budget, The City of New York.)

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