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Bond credit risk valuation rule-of-thumb

Bond credit risk valuation rule-of-thumb post image

There’s a rule-of-thumb you can use to evaluate when risky, higher-yielding bonds may be worth investing in.

Sadly the hour typically arrives when entering a market looks as suicidal as entering Deathtrap Dungeon in search of fame and fortune.

Apparent probability of death: Near certain!

We saw in part two of our Emerging Market bonds series that this sub-asset class’s historic outperformance has been driven by spikes in credit risk, following market hammerings.

Crisis-charged yields offered a profit opportunity to those who heeded Warren Buffett’s maxim: “Be fearful when others are greedy. Be greedy when others are fearful.”

So I asked hedge fund quant and Monevator reader ZXSpectrum48K if there’s a bond market signal that can help us recognise these decisive moments.

Beware all ye who enter here

Warning: what we’re about to discuss is a very rough rule-of-thumb. It is not an iron law of bonds, and you can have no expectation of profiting from it.

Think of this bond credit risk valuation method as analogous to the cyclically-adjusted P/E ratio (aka CAPE).

Its efficacy is highly debatable. It relies on mean-reversion to a historical ‘average’ that may not apply in the future.

You’ll also need considerable fortitude and spare financial firepower to burn if your judgement proves wrong.

With that said, let’s gird our loins and push into the dungeon’s maze.

Yield and spread

Yield and spread may sound like sweet-nothings whispered on a medieval speed-date but they’re actually the key metrics for ZX’s money.

That’s because his rule-of-thumb enables him to estimate the credit spread of a high-yield fund versus an appropriate benchmark, such as US$ Treasury bonds.

The credit spread compensates you for the default risk inherent in high-yield bonds.

A wide spread may mean the market is over-reacting to recent waves of defaults or anticipated risks. You’ll win if you invest when the credit spread runs ahead of the default rates that actually occur.

By comparing the spread against historic norms, you may get a sense of when to press deeper into the gloom in pursuit of treasure.

I’m going to leave out ZX’s maths and cut to the chase:

Step one: Find the yield-to-maturity (YTM) and duration of the high yield bond fund you’re interested in. These metrics should be published on the fund’s web page or factsheet.

Step two: Subtract the YTM of an equivalent duration US$ Treasury bond fund from your first bond fund’s YTM.

The difference in those yields is a reasonable approximation of the credit spread.

The wider the spread, the riskier your bonds are judged to be by the market.

If Buffett’s adage and market history holds then periods when the credit spread widens could herald an opportunity.

Note, you need to have some sense of historical credit spread fluctuations in your market.

Bond credit risk valuation in practice

Following on from our series on risky Emerging Market bonds, I looked at the iShares Emerging Markets Government Bond Index Fund.

It follows the market-leading index1 for EM US$ sovereign bonds, so is a useful proxy for that sub-asset class.

I’ll compare our fund with iShares $ Treasury Bond 7-10yr ETF. This is the closest duration match I can find among the available US Government bond funds.

Here’s the Emerging Market bond fund’s numbers:

Yield-to-Maturity (YTM): 4.09%

(iShares publishes the yield-to-worst for this fund but that’s close enough for our purposes.)

Modified duration: 7.77

Here’s the US$ Treasury fund’s numbers:

Yield-to-Maturity (YTM): 1.4%

Modified duration: 7.96

Approx credit spread = Credit risk bond fund yield minus US Treasury fund yield.

4.09 – 1.4 = 2.69%

How does 2.69% compare to the credit spread history of the EM US$ sovereign bond fund’s index?

This chart shows the index’s spread over US Treasuries:

A chart plotting the declining credit spread of Emerging Market bonds (1997-2021)

The spread sank to an all-time low of 1.66% in May 2007. (That’s 166 ‘basis points’ in the chart above.)

2.69% is the tightest spread since January 2018.

What does that tell me, according to our rule of thumb?

It suggests this is probably not an auspicious time to load up on Emerging Market US$ sovereign bonds – at least on this metric.

Better bookmark this four-part series after all, and come back when the rule of thumb is flashing green!

Take it steady,

The Accumulator

  1. The JP Morgan Emerging Market Bond Index Global Diversified. []
{ 7 comments… add one }
  • 1 Brod August 4, 2021, 12:24 pm

    @TA – thanks, interesting.

    I appreciate the case of EM Bonds as an alternative to equities, but for me flight to safety is why I own bonds. So bonds for ballast and equities for excitement. Plus of course cash for calamities and gold for God know why (or what?)

  • 2 JimJim August 5, 2021, 7:22 am

    I have followed this series of articles and its logic and it has educated me.
    It is definitely on the risk side of any purchases I might be tempted to make. Looking at your last graph, I read that purchases would have been best timed about the times of the major stock market dips – Which would also be the times any spare capital might be employed in other risk assets (Stocks + Shares).
    I am curious to see if one outperformed the other after major market movements.
    Any education to the bond side of investing is an addition to my knowledge as bonds have not played an important role in my investments to date due to the bond like nature of my DB pensions.

  • 3 The Accumulator August 5, 2021, 9:01 am

    Thanks Brod and JimJim. It’s been an education for me too and that’s why I’ve written it up. I’ve not dug so deep into junk bonds before, though I appreciate it’s very niche. Personally I find bonds quite counter-intuitive and I think there’s a fair few among the Monevator crowd who feel the same.

    @ JimJim – it certainly looks like EM bonds have outperformed EM equities for much of the period although the lead does change hands. The major spike in credit spreads in the graph is in the late nineties and not the dotcom bust. The various EM financial crises are to blame but perhaps those markets were less correlated to the global economy then.

  • 4 mr_jetlag August 5, 2021, 8:27 pm

    @TA – I preferred Trial of Champions (the sequel FF book)! You’ve just spurred me to find reprints as my old copies are sadly lost.

    On EM bonds, I’m not a buyer of alt assets in general and prefer to keep things simple where my SIPP is concerned. However, like everyone else I’m concerned about the gravity defying equities market and probably need to have a plan for the next downturn.

  • 5 SemiPassive August 6, 2021, 3:12 pm

    Worth keeping an eye on US T vs EM $ credit spreads, but in an ultra low yield world surely the spreads will typically be narrower than they were when US Treasuries were yielding 4, 5, 6 or higher %.
    And in January 2018 the US 10 yr was yielding double what it is now.
    So maybe the valuation formula needs a minor tweak, some kind of variable weighting depending on how low the “risk free rate” is.
    If that makes sense?

  • 6 The Accumulator August 6, 2021, 4:07 pm

    @ Mr Jetlag – I didn’t make it to Trial Of Champions. Deathtrap Dungeon was the first one I played. By torchlight under the duvet so parents wouldn’t know I was awake. Ridiculously vicious adventure. I needed a lot of alternate timelines to make it through that one.

    I don’t know what happened to my old copies either.

    @ SemiPassive – It does make sense. A similar argument is used to partly justify sky high p/e ratios in a low interest rate world. People are prepared to pay more for the future cashflows of equities when the risk-free rate is near zero. Still, the formula comes from someone working at the sharp-end so I wouldn’t want to second guess.

  • 7 Ben August 6, 2021, 6:33 pm

    As you suggest at the beginning, this rule of thumb isn’t strong enough to imply that you should try to time the market. I’ve tested this by backtesting allowing my bond allocation to vary by spread (or equity by CAPE) and it adds nothing. I say waiting for a green light is a mug’s game.

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