Is it Time to Invest in Leveraged Debt?

In the week ended January 11, 2018, retail investors poured $2.65 billion into the high yield bond market.  Was this a good idea?

The chart below describes the historical yield experience investors have enjoyed (sometimes endured)  through their investments in leveraged debt.

Leveraged debt includes all below investment grade (“junk”) debt obligations of large issuers including corporations and certain governments. They are called below investment grade because the issuers have issued large quantities of debt, face significant operational problems or both.  Rating agencies assess the likelihood these issuers will default and assign credit ratings ranging from “BB” (good junk) to “B” (questionable junk) to “CCC” (risky junk).

The chart above shows that credit risk premiums were close to historic lows in early January. 

The chart above presents credit risk premiums by rating category over a period of more than 20 years.  The credit risk premium is the compensation in excess of treasury yields received by investors for investing in corporate debt.  To create a simple example, an investor in a the Merrill Lynch BB rated bond index on January 5, 2018 would expect to earn:

  Credit Risk Premium + Treasury Bond Yield = Expected Return

                  1.99%           +      2.40%           =   4.39%

The yield on 7 year US Treasury bonds on January 5 was 2.40% (we assumed the average term to maturity on bonds in the index approximates 7 years).  When we add the credit risk premium on “BB” rated bonds of 1.99%, we obtain an expected return of 4.39%.  In the case of an individual bond, the expected return might also be described as the yield to maturity.

The chart above shows that credit risk premiums on below investment grade debt vary widely during the course of the business cycle.  During good times, investors are calm and do not require large credit risk premiums.  During tough times, investors are fearful and expect much larger returns for putting cash to work in risky investments.  Since the contractual rate of interest on a bond is fixed, an increase in the required return is reflected in the price at which the bond trades in the secondary market. 

In an extreme case, if the required return (treasury yield + credit risk premium) on a bond with a 5.0% contractual interest rate increases to 20.0%, the bond’s price changes as follows:

  5.0% coupon / 20.0% required return = 25

In this example, the bond’s price would fall by 75% to 25 cents on the dollar.

The low points of the graph above represent moments when bonds are expensive (unattractive) relative to their long term average prices and the high points on the graph represent moments when bonds are inexpensive (attractive).

The chart below converts the credit risk premiums described in the first chart into approximate historical prices.  For simplicity, we calculated prices assuming the average high yield bond in each index had a remaining term to maturity of seven years and paid an annual cash coupon of 7.0%. 

This chart reflects the fact that leveraged debt investment prices are subject to significant changes in value over time.  Because these investments are subject to high degree of risk, investors should exercise caution when investing in them.

The next six articles in this series provide important background information regarding the leveraged debt markets (Article #2) and guidance regarding when to invest and how to structure investments in leveraged debt (Articles #3 through #7).

Outlook and Conclusions

The last broad correction in leveraged debt began in the third quarter of 2007, more than 40 quarters ago.  Credit risk premiums are nearing their all time lows and structural market changes could make it difficult to every reach previous lows (see Article #3).

We do not anticipate a significant correction in the leveraged debt markets in 2018 but we believe that, as of early January 2018, leveraged debt investments presented modest return potential with significant risk of future loss.  Timing is important to successful investment in leveraged debt. 

Active investors who vigilantly monitor economic and market conditions will likely be able to wring further gains from this increasingly dry market.  Passive investors may find that the risks presently outweigh the rewards.

Coming Articles

Article #2:  Leveraged Debt Investment Alternatives

Article #3:  Can Leveraged Debt Retest Low Premiums?

Article #4:  Signs That It’s Time to Sell Leveraged Debt

Article #5:  Signs That It’s Time to Buy Leveraged Debt

Article #6:    The Appeal of Investing in Distressed Debt

Article #7:   Investment in Leveraged Debt through the Business Cycle

Thereafter:  Updates regarding important market statistics with current commentary

Data Sources for the Article

The data presented in this article was obtained from the Federal Reserve Bank of St. Louis (ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield B Option-Adjusted Spread [BAMLH0A2HYB], retrieved from FRED, Federal Reserve Bank of St. Louis;, January 8, 2018) and from the Leveraged Commentary and Data news service provided by Standard and Poors Corporation.

For more information, contact:

If you liked this blog you may enjoy reading some of our other blogs here.

Print Friendly, PDF & Email
© 2018 ValueScope Inc. – Measure | Defend | Create