(The views expressed here are those of the author, the

publisher of Income Securities Investor)

By Marty Fridson

NEW YORK, July 23 (Reuters) - Credit spreads on so-called

"junk bonds" may appear slim compared to historical averages.

But that says more about the analytical method being used than

the fair value of these instruments.

As their more appropriate name - high-yield bonds -

suggests, these speculative-grade bonds offer investors more

current cash income than fixed income instruments with higher

credit ratings. But they also have more downside potential

during tough economic times because of the elevated default

risk.

One number that debt managers consider when determining

their high yield weighting is the average spread versus

Treasuries. Simply stated, that's the amount of extra yield

investors receive for accepting the risk of speculative-grade

bonds rather than the so-called risk-free asset.

From 1997-2025, the monthly average spread was 5.23

percentage points, based on the Option-Adjusted Spread (OAS) of

the ICE BofA US High Yield Index. On July 21, the spread was

roughly half that at 2.69 percentage points.

So does that mean high-yield spreads are too thin?

Let's first consider the traditional analytical approach. As

Investopedia - a decent source for conventional financial wisdom

- notes, "The high-yield bond spread is most useful in a

historical context, as investors want to know how wide the

spread is today compared to the average spreads in the past. If

the spread is too narrow today, many savvy investors will avoid

buying into junk bonds."

There's a fundamental flaw in this reasoning, however. The

high yield spread is a risk premium. If risk is higher than

average at a given time, the risk premium should be greater than

average as well. Determining whether high-yield bonds as a class

are currently rich or cheap requires a comparison of the spread

with the prevailing risk.

There's one further problem with comparing the U.S.

high-yield index's spread with its historical average. Over

time, the index's composition has shifted to a lower risk

profile.

Currently, the lowest-quality tier, with ratings of CCC or

below, accounts for just 10% of the index's total face value

amount. Ten years ago, the comparable figure was 16%. Secured

bonds, which provide a higher recovery rate in the event of

default than unsecured bonds, have doubled over that period,

from 18% to 37% of the total face value amount.

These changes don't mean that, for example, the average BB

unsecured bond is either riskier or less risky than in the past.

But because of the dramatic improvement in the quality of bonds

in the index, you'll see a narrower average spread, based on a

fair value analysis, than you did in earlier times, all else

being equal.

FAIR VALUE

By failing to account for either the present level of credit

risk or the change over time in the index's composition,

adherents of the historical average method will conclude that

the high-yield bond category is currently drastically

overvalued.

But when using a fair value model that takes into account

credit availability, economic conditions, and Treasury yields,

you get a dramatically different message.

After taking all of these factors into account, my analysis

puts the fair value spread of today's high-yield market at 2.66

percentage points. That is to say, the high-yield index - with

its current OAS of 2.69 percentage points - is currently priced

roughly where it should be - or, to be more precise, a bit wider

than my model estimates. That means you're actually earning more

yield, on average, than the risk level necessitates.

FAIR WARNING

Let me hasten to add that the spread should get a great deal

wider once the next recession approaches. In that environment,

credit conditions should tighten, economic indicators should

weaken, and Treasury yields should decline. Based on historical

norms, the high-yield spread could increase to 10 percentage

points - or even higher.

That would obviously put the index's yield far above the

current 6.97%, producing a deeply negative total return on

high-yield bonds.

Does that mean investors should avoid high-yield bonds if

they think a recession is coming? Not necessarily.

Investment-grade bonds, rated BBB or higher, also typically

go into the red during recessions.

Even Treasury bonds, as measured by the ICE BofA US Treasury

Index, have inflicted negative returns on investors in 37% of

quarters from 1997 onward, though this was not usually when

there was a recession but during periods when interest rates

were rising.

Of course, you could have completely avoided interim losses

by owning only three-month Treasury bills. From 1997 through

2025, those super-steady instruments produced a 2.32% annualized

return. But given that this is less than the period's 2.66%

average inflation rate, you would have been in the red on a real

basis.

Most investors would probably prefer the 1997-2025 average

annual returns of 3.84% on Treasuries, 5.10% on investment-grade

corporates, and 6.45% on high-yield bonds.

"Junk bonds" will assuredly have their share of down

quarters. But that's no reason to avoid them entirely,

especially at times when they appear to offer fair value for the

risk.

(The views expressed here are those of Marty Fridson, the

publisher of Income Securities Investor. He is a past governor

of the CFA Institute, consultant to the Federal Reserve Board of

Governors, and Special Assistant to the Director for Deferred

Compensation, Office of Management and Budget, The City of New

York.)

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(Writing by Marty Fridson; Editing by Anna Szymanski and Nia

Williams)