The current B grade bond spread to US Treasuries is 260 basis points for 10 year bonds, and the average default rate since 1970 has been about 6%, and recovery rates about 50%. So on average, a B grade bond portfolio, with no turnover, should expect to return slightly less than Treasuries (260-300= - 40).



The historical record of high yield bond portfolios is consistent with this observation. Bloomberg’s B rated bond series starts only in 1992 when B spreads were a little above what they are today, around 300 basis points (thus making it a fair comparison start date). Merrill Lynch’s HY Index and Government Bond Index from that date show similar increases, a little over 8% annualized. The annualized standard deviation is also similar (about 7% annualized), as for HY bonds the extra volatility of the spread risk is mitigated by the fact spread movements are inversely correlated with interest rates (spreads go up when the economy is weak and rates go down).

Thus a simple forward looking calculation (260 bp spread vs 300 bp expected loss) or historical performance suggest you do not get rewarded for taking on extra credit risk.

Given the extra risk of HY bonds, why invest in them now? Most people I know say they know that on average HY bonds are a bad trade, but they will get out before the next recession, which currently appears at least a few years away. That kind of reasoning invokes the greater fool theory (I'll sell to some fool before he notices the impending recession). But I imagine that bond yields will spike not in the next recession (which is well off), but at the faintest hint of trouble as holders simultaneously try to cash in on the greater fool theory. In other words, the next HY crack-up will not occur during the next recession or the next financial crisis, but rather the next symptom of an impending symptom of a recession, which will happen much sooner.

The stated yield may be high, but the net returns are not.