Since the option-adjusted spread (OAS) of high-yield bonds reached extreme levels in late March from COVID-19 fears, as represented by the ICE BofA US High-Yield Constrained Index (HUC0), high-yield bond spreads have experienced a dramatic recovery from a wide of 1,087 bps on March 23, 2020, to the current level of 631 bps, as of June 25, 2020. Naturally, the question investors must be asking is, "Have I missed it?". We believe the answer is, "No".
While high-yield bond OAS has improved since the dramatic dislocation in March, spreads continue to remain above their long-term average of 552 bps. In addition, spreads remain 271 bps wider than the 360 bps at the beginning of the year. Empirically, we can evaluate how investors would have fared historically if entering the market under similar circumstances. There have been 10 similar occurrences prior to the COVID-19 pandemic when high-yield bond spreads ended the month above 600 bps AFTER a dislocation in spreads. Said differently, when high-yield bond spreads widened beyond 600 bps and subsequently recovered to 600 bps, the following 12-month holding period average return was 9.27% and the median return was 10.71%. Moreover, in none of those 10 instances would an investor have experienced a loss. Furthermore, HUC0 exhibited strong returns over a 24-month holding period with an annualized average return of 8.12% and a median annualized return of 9.36%. In only one instance out of the 10 periods would an investor have experienced a loss. That period was from November 1998 to November 2000 with a -2.64% average annualized return.
In summary, we believe a rapid tightening in high-yield bond OAS should be interpreted as validation for a continued recovery. Conversely, when the high-yield bond OAS widened beyond 600 bps but didn't recover back to 600 bps, it tended to suggest a long period of volatility, as evidenced in the graph below over the period of 2000-2002, when the spreads remained well wide of 600 bps.