In my previous article about high yield spread, I was explaining that it is the right timing to trade high yield bonds when there is an abnormal spread between the corporate yields and the federal bond yield. Some of you may think you obviously missed a great trading opportunity in 2009.

In fact, the high yield spread is now similar to the one observed back in 2007. This means that the panic we went through in 2008-2009 is over and the investors are now giving more value to the corporations and fear less to see them default their loan (bonds).

The demand for corporate bonds in 2009 was higher than the offer. Since the economy and the credit facilities have greatly improve as well, the high yield spread started to shrink back to a normal level. In addition to that, default payments were drastically dropping (1 case only in December 2009).

Back in 2009, the high yield bonds was one of the best performing asset class according to Merrill Lynch.

While the spread is getting smaller, there is still a trading opportunity. The high yield spread should decrease during the next 2 years. Most economists expect to see it shrink by another 100 basis point in 2010.

If the unemployment rate starts decreasing and the economy is rolling back, the bond value will follow the same trend and the yield spread will diminish. This is why there is still a trading opportunity in 2010. However, don’t expect to make astronomic yield as it was the case in 2009 (more than 30% for the high yield bond asset class).

If interest rates start going up, the high yield bonds might be the only bond class to show a positive results as their price doesn’t only fluctuate according to the rates, it also follow the stock market (as they are related to public companies).

Then again, instead of trading high yield bonds, I suggest to use ETF’s.

What is a High Yield Spread?

The high yield spread is the difference in yield between federal bonds (which offer virtually no default risks) versus the yield on corporate bonds. High Yield bonds (also called junk bonds) are issued by corporations to finance their activities or purchases. However, since their balance sheet is not that great, they have to offer a higher yield to attract investors. This is why we call them High Yield Bond.

Here is an example: if a federal bond offer 3% for 5 years and a company needs financing, it may issue bonds offering a 6% yield. The difference (3%) is called the yield spread. Since the company represents more economic risks than the federal government, it has to offer a higher yield to compensate the investors and encourage them to invest in their bonds instead of the governments.

When the market panics, the High Yield Spread increase

high yield spread

As you can see in the picture above, the difference between provincial bonds / corporate bonds and federal bonds increase significantly during market crisis. If you look at the graph in 2008 (credit crunch) and 2002 (world trade center, Tyco, World com and Enron bankdruptcy), you can see that investors request much more yield to compensate the default risk than during good economic period.

The second observation to make is that the high yield spread reduces as the economy is growing (from 2002 to 2007). Therefore, you can find some great trading opportunities by following the high yield spread trend.

How to trade according to the high yield spread?

Instead of selecting your own high yield bonds by looking at company financial statements, you can buy ETF’s related to high yield bonds. Here are 3 major high yield bonds ETF’s on the US market:

JNK (SPDR Capital High Yield)

EMB (ISHARES JP Morgan Emerging Market Bond)

HYG (ISHARES High Yield Corp Bond)

You can trade those ETF’s in any brokerage account. The key point is to trade them when the high yield spread is very high and wait until the economy comes back.