Junk Bond Selloff: More Than A Pullback?

August 12, 2014

Options-Adjusted Spreads

High-yield bonds, also known as junk bonds, are bonds that one or more rating agencies (S&P, Moody’s and Fitch) has rated as below investment grade based on probability of default.

These bonds, in the most simplistic terms, are priced off of risk-free assets of similar maturity characteristics. Treasury yields are often used as the risk-free rate for pricing. Beyond that, junk bond investors demand additional compensation based on credit risk, also known as the credit spread.

Some bonds may also have embedded option features that also affect their interest rate sensitivities and values.

Adding it all up, the OAS is a popular metric that an investor can look at to see how well he/she is being compensated for the additional credit risk. In other words, OAS is a good reflection of credit risk.

While not tracked by any existing ETF, the Bank of America Merrill Lynch US High Yield Master II OAS provides a pretty good overview on the historical trend of U.S. corporate high-yield bond OAS. (Data is available via St. Louis Federal Reserve Economic Data (FRED).)

BAML_OAS

A quick glance at the historical OAS quickly shows that current OAS is below both historical average and median but not quite there yet with respect to historical low. Will the reversion to the mean occur, or a resumption of further OAS compression? Let’s look at another data series for possible hints.

 

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