Howard Marks On High Yield Bond Risk ("How Quickly They Forget"), U.S. High Yield Option-Adjusted Spread

Howard Marks, chairman of $85 billion private equity firm Oaktree Capital, released a memo to clients on 5/25/2011 titled "How Quickly They Forget (pdf)". Historical data from the memo:

High Yield Bond Spread vs. Treasurys (the risk free rate, supposedly) in basis points

"Normal" - December 31, 2003 - 443 bps
Bubble peak - June 30, 2007 - 242 bps
Panic trough - December 31, 2008 - 1,773 bps

Recovered - March 31, 2010 - 666 bps
Shrinking again - April 30, 2011 - 492 bps"

Are high yield bonds starting to underprice risk? Marks thinks they have become flowers again (Warren Buffett invests in weeds).

"High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time."

But does the credit market overshoot again like it did in 2007? Will the 10-year Treasury yield 0.76%? Or does a new recession widen credit spreads from here. If bond vigilantes cause a "thundering conflagration" in the Treasury bond market, that could force yields higher as well. That isn't happening yet. Marks made sure to note that he doesn't "believe security prices have returned to the 2006-07 peaks."

Check out the US High Yield CCC or Below Option-Adjusted Spread chart since 1997 (via St. Louis Fed FRED database). Watch for a turn. Description: "The Bank of America Merrill Lynch OASs are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve."


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