Posted on Wednesday, 13th January 2010 by admin
There is a trading technique that allows you to trade on the high yield spread. This happens when there is a “panic” in the stock market and the junk bonds drop in value, increasing the yield spread between junk bonds and federal bonds.
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.
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