There’s a rule-of-thumb you can use to evaluate when risky, higher-yielding bonds may be worth investing in.
Sadly the hour typically arrives when entering a market looks as suicidal as entering Deathtrap Dungeon in search of fame and fortune.
Apparent probability of death: Near certain!
We saw in part two of our Emerging Market bonds series that this sub-asset class’s historic outperformance has been driven by spikes in credit risk, following market hammerings.
Crisis-charged yields offered a profit opportunity to those who heeded Warren Buffett’s maxim: “Be fearful when others are greedy. Be greedy when others are fearful.”
So I asked hedge fund quant and Monevator reader ZXSpectrum48K if there’s a bond market signal that can help us recognise these decisive moments.
Beware all ye who enter here
Warning: what we’re about to discuss is a very rough rule-of-thumb. It is not an iron law of bonds, and you can have no expectation of profiting from it.
Think of this bond credit risk valuation method as analogous to the cyclically-adjusted P/E ratio (aka CAPE).
Its efficacy is highly debatable. It relies on mean-reversion to a historical ‘average’ that may not apply in the future.
You’ll also need considerable fortitude and spare financial firepower to burn if your judgement proves wrong.
With that said, let’s gird our loins and push into the dungeon’s maze.
Yield and spread
Yield and spread may sound like sweet-nothings whispered on a medieval speed-date but they’re actually the key metrics for ZX’s money.
That’s because his rule-of-thumb enables him to estimate the credit spread of a high-yield fund versus an appropriate benchmark, such as US$ Treasury bonds.
The credit spread compensates you for the default risk inherent in high-yield bonds.
A wide spread may mean the market is over-reacting to recent waves of defaults or anticipated risks. You’ll win if you invest when the credit spread runs ahead of the default rates that actually occur.
By comparing the spread against historic norms, you may get a sense of when to press deeper into the gloom in pursuit of treasure.
I’m going to leave out ZX’s maths and cut to the chase:
Step one: Find the yield-to-maturity (YTM) and duration of the high yield bond fund you’re interested in. These metrics should be published on the fund’s web page or factsheet.
Step two: Subtract the YTM of an equivalent duration US$ Treasury bond fund from your first bond fund’s YTM.
The difference in those yields is a reasonable approximation of the credit spread.
The wider the spread, the riskier your bonds are judged to be by the market.
If Buffett’s adage and market history holds then periods when the credit spread widens could herald an opportunity.
Note, you need to have some sense of historical credit spread fluctuations in your market.
Bond credit risk valuation in practice
Following on from our series on risky Emerging Market bonds, I looked at the iShares Emerging Markets Government Bond Index Fund.
It follows the market-leading index1 for EM US$ sovereign bonds, so is a useful proxy for that sub-asset class.
I’ll compare our fund with iShares $ Treasury Bond 7-10yr ETF. This is the closest duration match I can find among the available US Government bond funds.
Here’s the Emerging Market bond fund’s numbers:
Yield-to-Maturity (YTM): 4.09%
(iShares publishes the yield-to-worst for this fund but that’s close enough for our purposes.)
Modified duration: 7.77
Here’s the US$ Treasury fund’s numbers:
Yield-to-Maturity (YTM): 1.4%
Modified duration: 7.96
Approx credit spread = Credit risk bond fund yield minus US Treasury fund yield.
4.09 – 1.4 = 2.69%
How does 2.69% compare to the credit spread history of the EM US$ sovereign bond fund’s index?
This chart shows the index’s spread over US Treasuries:
The spread sank to an all-time low of 1.66% in May 2007. (That’s 166 ‘basis points’ in the chart above.)
2.69% is the tightest spread since January 2018.
What does that tell me, according to our rule of thumb?
It suggests this is probably not an auspicious time to load up on Emerging Market US$ sovereign bonds – at least on this metric.
Better bookmark this four-part series after all, and come back when the rule of thumb is flashing green!
Take it steady,
The JP Morgan Emerging Market Bond Index Global Diversified.
We love a rule-of-thumb. It helps you feel like you’re in control. The reality is far different of course…
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