The concept of high-yield corporate bond spread is a key indicator for the stock market. The bigger the spread, the more worried investors are about the market, and vice versa. This spread is the difference between the yield of bonds from riskier companies and the yield of risk-free Treasury bonds. If the spread grows, it means investors are worried these companies might not pay back their debts fully or on time.
Here’s an example: as of the last quarter of 2022, the average high-yield corporate bond spread is about 5%, which is the historical long-term average. Recessions have typically occurred when the spread exceeds 7.5%. In simpler terms, high-yield bond investors are currently asking for a yield of about 9.1%, which is 5% more than the risk-free rate of return of around 4.1%. The risk-free rate is the yield of a 10-year Treasury bond.
When the spread hits about 7.5% (meaning a high-yield of 11.6% versus a risk-free rate of 4.1%), there’s a higher chance of economic downturn. A large spread suggests that investors believe there’s a higher risk of companies defaulting or missing payments, which usually happens during economic stress.
As of now, high-yield corporate bond investors are fairly comfortable about the future, demanding only an average return of 5% more than the risk-free rate. But remember, the high-yield corporate bond spread is always fluctuating.
Let’s look at a real-world example. Consider a bond from Carvana (CVNA) with a coupon rate of 10.25% and a maturity date of May 1, 2030. The last trade yield is a whopping 22.428%, which you’ll get if Carvana doesn’t default for a year.
Assuming the company doesn’t call the bond, an investor could buy the bond at its current price of 56.69 cents on the dollar, earn a 10.25% annual coupon rate for five years, and then get 100 cents on the dollar upon maturity. Sounds good, right? But are you ready to take that risk? There’s a reason why the company’s stock price has dropped 95% since August 2021. And if Carvana survives, will it continue to pay such a high coupon payment if inflation and interest rates drop significantly before the maturity date? That’s doubtful.
This example should help you understand the concept of looking at high-yield bond spreads over the risk-free rate of return. In this case, the spread is about 6.15% (10.25% minus 4.1% for the 10-year bond yield today). Then you have to consider the potential of being paid back fully at maturity.
As an investor, we need a return above the risk-free rate to compensate us for taking on risk. The bigger the spread, the bigger the perceived risk. Conversely, the smaller the spread, the lower the perceived risk. The more financially stable the borrower, the lower their borrowing cost.
For instance, if Harvard University issued a 5-year bond at 5%, only 0.9% above the current 10-year bond yield, that small spread might be attractive enough because we know there’s a strong demand for families to pay high tuition rates for the prestige and status.
If a billionaire like Elon Musk wanted to borrow money as a bridge loan, a lender probably wouldn’t need as high of a risk premium (spread). If the risk-free rate is 4.5%, the lender might even lend at parity to try and win more business from Elon in the future.
This concept of bond yield spread also applies to your personal financial needs. If you’re content with the wealth you’ve already built, you won’t need a large spread. The same goes if you’ve overcome greed by giving up your maximum money potential. You’re more satisfied investing in lower-risk assets.
Personally, I’m happy with the passive income my portfolio is generating now. Thanks to a bear market, it’s easier to generate more passive income. I estimate our 2023 passive income will increase by 10%.
Given we live off less than $250,000 gross, there’s no need to take excessive risk. Buying Treasury bonds yielding 4.5% and investing in real estate crowdfunding for hopefully 7% – 10% passive returns is what I favor.
Our main goal with two young children is to stay retired. We want to spend as much time with our children as possible before they both go to school full time. The worst thing that could happen is if we invest in risky assets that plummet and cause us to return to work.
The yield spread concept also applies to understanding the proper safe withdrawal rate in retirement. Instead of following a fixed withdrawal rate, I recommend following a dynamic withdrawal rate. Be adaptable with the changing times!
I have a feeling one of the reasons why so many people have bashed me over the head about my dynamic FS Safe Withdrawal Rate Formula is because they don’t understand how everything revolves around the risk-free rate of return.
But just like how we no longer burn witches at the stake, with more education, we slowly stop vilifying people and things we don’t understand. The vilification of others is also why some people prefer to stay quiet or agree with everything someone says, despite knowing a better solution.
The higher the risk-free rate, the higher your safe withdrawal rate in retirement and vice versa. It makes sense to be able to increase your safe withdrawal rate when the risk-free rate increases because you can earn more passive income in a bear market.
Whether we’re talking about the significance of the high-yield corporate bond spread for stocks or figuring out the appropriate asset allocation, never stop learning.
Always remember the importance of the risk-free rate of return. All risk assets are priced off of it.
If you want an easy financial reference that puts you ahead of probably 95% of the population, read my book, Buy This, Not That. It is an instant Wall Street Journal bestseller. I go deep into the most important topics you should all know about.
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