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Call#1: Remain neutral on US high yield bonds

I’ve been getting a lot of questions about high yield bonds recently. And no wonder: The spread between high yield bonds and comparable Treasuries is now roughly 7%. It’s no surprise that investors are taking a look at high yield as a way to enhance income.

Not so fast, unfortunately. There can certainly be a place for high yield in a fixed-income portfolio. But the extra yield comes with more risk, something investors need to take into account.

There are two important things to consider with high yield: first, these bonds are more volatile than Treasuries — or even investment grade bonds — of a similar duration; and second, high yield tends to be particularly sensitive to economic growth. As such, these bonds typically perform well when the economic environment is stronger, unlike Treasuries. It is this very concern over the sustainability of the recovery that has caused high yield bonds to sell off, which has driven up their yields in the process.

So the question for investors is: Are the current yields high enough to justify the extra risk you’re taking, particularly given the fragile state of the recovery?

My analysis suggests that the answer is not yet. While high yield looks attractive relative to the current level of growth in the United States, when you adjust the picture for the risks in Europe, these bonds look close to fair value currently. In other words, in order to get more bullish on high yield, I would need to see even higher yields to justify the incremental risk or some improvement in the economic landscape. In the absence of either development, I’d remain neutral for now. Instead, within fixed income, I’d favor taking overweight positions in municipals and investment grade bonds.

Call #2: Maintain defensive position in equities

Recently, I wrote about the risks to equities in September, given not only the weak economic landscape, but also the negative seasonality that tends to accompany September. This is particularly true when the market is down year-to-date as it is this year.

So far, the numbers have been even worse than usual. US stocks are down over 7% month-to-date (as of September 23rd) while a broader universe of global equities is down around 11%. Yes, stocks have become cheap, but I would expect the volatility to continue until we have some clarity over Europe, as well as some evidence of stabilization in the global economy.

In the meantime, I’ll stick with my preference for defensive sectors, specifically US healthcare and global telecommunications. US healthcare has outperformed the S&P 500 by roughly 2% this month, while global telecom has outperformed a global benchmark by around 4%.

 

Bloomberg:

Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.  A portion of a municipal bonds fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.   Narrowly focused investments typically exhibit higher volatility.