Buy Illiquid Risky Assets When High Yield Spreads Are Wide

During his recent interview on The Acquirers Podcast with Tobias, Dan Rasmussen of Verdad Capital discussed Buying Illiquid Risky Assets When High Yield Spreads Are Wide. Here’s an excerpt from the interview:

Tobias: We’re in a regime with very low rates. Does the signal become less useful in this regime? Have you looked at it over more extended periods?

Dan: Yeah. Well, I think one testament to that not changing is how well it worked in COVID. It was a great indicator during COVID. It spiked up massively, and then it came down, just as the economy started to recover, and the market start– or actually anticipated the market recovering. It remains the best indicator, and remember, it’s a real market indicator. You’re just saying, “Well, how are high yield bonds being priced relative to treasuries?” It’s pretty hard to manipulate that. That’s real lending activity, real investor dollars.

Yes, the Fed could go and buy high yield bonds, and maybe they did a little bit of that, really, they threatened to do it, and they didn’t do that much of it. Still, that’s having a real impact. That’s going to reset the prices of borrowing.

That has a real-world economic impact. If borrowing is easy, fewer things go bankrupt, and more projects get financed, and there’s more growth, and conversely, when blending is really expensive or limited if things don’t get funded, and again, real world economic implications. It’s called the financial accelerator. It is not diminished once you use it as a signal.

The other signal which we found was useful, was when high yield spreads are wide, that’s the governing decision maker. Just go buy illiquid, risky assets when spreads are wide, it’s a really good trade. When spreads are narrow, that’s a more complex set of decisions, and that’s when you have to think more about real rates, and where the yield curve is, and some other economic variables which are less, less predictive than the high yields.

The high yield spread is wonderful. It’s really powerful, and it predicts a whole range of asset classes. Other economic variables are much weaker, and predictive signals are less weaker than the high yield spread.