Are High Yield Bond Prices Rich or Cheap?

July 31, 2015

2 minute read

Are High Yield Bond Prices Rich or Cheap?

Carl Icahn recently made some comments at the CNBC Delivering Alpha conference about the High Yield market:

“More importantly, they are overpriced, because if you go down and look at the index — and now I could get into some arcane stuff, but what a lot of these guys do, including BlackRock and the others, is these things — high-yield bonds, as you know, if you trade them, are quite illiquid. And therefore, if somebody wants to buy them, they do what they call CDS. They sell insurance on them. So take the money they are given, buy five-year Treasurys, then they go and they buy insurance from a guy like me. As a result, I personally think the illiquidity increases. So these high yields are extremely illiquid and extremely overpriced.”

Focus on his last sentence for the moment and forget about the fact that the rest of his statements don’t make much sense at all (first he says buyers sell insurance via CDS, then he says they buy insurance…?)

Ichan says the HY market is illiquid and overpriced. I’m not going argue that liquidity is great, but then again, it has never been tremendous for individual bonds. The big question is whether or not the liquidity situation is already factored into the price. The average option-adjusted-spread for the HY market since 2012 is 440 bp (According to the Barclays HY Index). The current OAS is 553 bp, close to the high end of the range over that period. Depending on how far back you look, OAS spreads are not “overpriced” as Icahn states.

The real concern for HY credit is the Energy sector where we are just beginning to see the ultimate impact of the repricing of crude. The energy sub-sector of the index trades at a spread of 975 bp. Whether that spread is sufficient cushion to absorb the upcoming defaults remains to be seen.

The most violent moves in a market tend to come when positions are crowded and investors get hit with some sort of negative surprise. The HY market has already re-priced to a large degree and the macro headwinds for the Energy sector are well known.

There is a saying in the bond market that “there is no such thing as bad bonds, just bad bond prices”. And it doesn’t look like prices are too bad right now.