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Why High-Yield Bonds Fell Despite Falling Treasury Rates

Article Quant Q&A · Author: Ian Fellows
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Summary

The document explains the sharp decline in high-yield corporate bond ETFs during the Great Recession despite falling interest rates. The key distinction is between Treasury yields and the yields investors demand on risky corporate debt. A high-yield bond’s yield includes both a Treasury component and a credit spread, which compensates investors for credit risk and related uncertainty.

As Treasury yields fell, credit spreads widened by more, pushing required yields on high-yield bonds higher and prices lower. The loss therefore cannot be read directly as evidence that the market expected an equivalent fraction of bonds to default: bond prices also reflect changing required compensation for credit risk. The response is brief and does not quantify the contributions of default expectations, recovery rates, liquidity, or other factors, nor does it address how a fixed-maturity ETF would behave as it approaches its termination date.

Key ideas

  • High-yield bond yields combine Treasury yields with credit spreads.
  • Falling Treasury rates can coincide with falling high-yield bond prices if spreads widen enough.
  • Credit-spread changes reflect required compensation for credit risk and are not a direct default-probability measure.
  • The explanation does not quantify other contributors to ETF losses or analyze fixed-maturity funds.

Tags

Fixed incomeUS marketsRisk management
Full text
# Why did high yield corporate bond ETFs tank during the great recession


# Why did high yield corporate bond ETFs tank during the great recession












My apologies if this is not mathematical enough for this outlet.

My understanding of the pricing of a bond ETF is that lowering interest rates drive the price up and increased risk of default drives the price down. I'm trying to wrap my head around the dynamics of what happened to high yield corporate bonds around the great recession. Looking at a few of them, they lost in the neighborhood of 50% of their value at the bottom of the curve, which is about the same loss as the S&P 500.

During this period interest rates went from 5.2% to near 0%. Absent changes in default risk, this would imply that the price should have gone up. Obviously default risk went way up during the recession, but wouldn't this price change essentially mean that the market was pricing in a >50% chance of default for the underlying bonds? That seems to me to be curiously excessive even given the environment at the time. Was default risk the only thing driving the loss of value, or were there other factors in play?

Bonus question: How would the recession have affected an ETF with a fixed maturation timeline, such as iShares iBond? How would maturation date relative to the recession have played a role?

## Answer by VanillaCall (score 2)

https://quant.stackexchange.com/a/46589

During the recession, when rates fell towards zero, we're talking about Treasury yields. The yield of a high yield bond is comprised of the Treasury yield and credit spread so even though Treasury yields fell, the credit spread widened much more which is whe prices fell sharply.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.