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Fridson: The Incredible Expanding High-Yield Overvaluation

Only on the brink of the massive price collapse of the Great Recession in 2008 has the high-yield market ever been as overvalued as it currently is, according to our Fair Value Model.

As of Sept. 30, the option-adjusted spread (OAS) on the BofA Merrill Lynch US High Yield Index was 497 bps. That amounted to a gap of negative 265 bps versus our fair value estimate of 762 bps, a difference of –2.1 standard deviations, where one standard deviation equals 126.3 bps. (Grantham, Mayo, Van Otterloo has proposed a general definition of a bubble in financial markets as a divergence of –2 standard deviations from intrinsic value.)

By Oct. 14, the OAS on the BAML High Yield Index was down to 472 bps, a gap of –290 bps or –2.3 standard deviations.
fridson spread

As detailed above, the present shortfall from fair value was greater only in April 2008 (–300 bps or –2.4 standard deviations) and May 2008 (–321 bps or –2.5 standard deviations).

Following the record overvaluation of the spring of 2008, the high-yield market did not return to fair value until October 2008, when the BAML High Yield Index’s OAS widened by an astounding 521 bps in a single month. Ominously, from April 30 to Oct. 31, 2008, the BAML High Yield Index returned –25.94% while the BofA Merrill Lynch US Treasury Index returned 1.79%. We do not foresee conditions comparable to those of 2008 any time soon, but high-yield’s currently extreme overvaluation nevertheless sounds a loud cautionary note.

By way of background, our basis for determining whether the U.S. high-yield market is fairly valued is the methodology introduced in “Determining fair value for the high-yield market.” We are now using an updated analysis to reflect revisions to originally reported economic data, based on a historical observation period of December 1996 to December 2012. – Martin Fridson

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This story is part of Marty’s weekly high yield analysis, available to subscribers at www.lcdcomps.com, an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.