With most signs pointing toward several more months of uninterrupted quantitative easing, it isn't too late to jump tactically into the high-yield bond market for a near-term portfolio boost.
High-yield bond mutual funds, up more than 5.6% from the start of the year, are clearly the hottest area of fixed income, and the near-term outlook is for more upside.
The key is to remain flexible in approaching any new high-yield exposure in this market, keeping a close watch on the Federal Reserve's plans to reduce the $85 billion-a-month bond purchasing program.
“If you think tapering is off the table until sometime in 2014, and if you think that companies are going to continue to have strong financial results, which we are seeing with earnings, you have to expect a positive impact on high-yield bonds,” said Todd Rosenbluth, an analyst at S&P Capital IQ.
The Washington donnybrook over the federal budget and the debt ceiling has effectively pushed tapering out until March at the earliest.
In fact, the weak September employment report — combined with the negative impact of the 16-day partial government shutdown — already is sparking speculation that tapering could be delayed until the summer months or later.
“If we continue to get employment reports showing just 150,000 jobs created, that idea of tapering starting in four or five months might become another 12 months,” said Thomas Meyer, chief executive of Meyer Capital Group.
He and other financial advisers see the record-level quantitative easing, with no firm end in sight, as more rocket fuel for risk assets, including high-yield bonds.
But anyone taking the bait this time around should be prepared to be nimble and even brazen in the approach.
“The Fed has thrown investors a lifeline by deciding not to start tapering yet,” said Jeff Tjornehoj, a senior research analyst at Lipper Inc.
“The Fed is signaling that it believes further quantitative easing is warranted, which will push investors into high-yield bonds and equities,” he said. “And as far as preferring riskier assets, I've even heard people say C-rated bonds might be the best opportunity.”
Considering that high-yield status begins with double-B rated and below, a C-rated bond might be pushing the envelope. But again, this is a near-term tactical play we are talking about.
“Yes, high yield is attractive right now, but there are also significant risks when your starting point is low interest rates and narrow spreads,” said Steve Blumenthal, chief executive of CMG Capital Management Group Inc., a firm that helps advisers manage bond portfolios.
The average junk bond yield is hovering around 6%, which is only 350 basis points higher than the yield on the 10-year Treasury bond.
That spread compares with a historical average of 500 basis points, which should remind investors of the potential for radical yield adjustments.
“Right now, the spread between high yield and Treasuries is close to the lows of the 1990s and 2006, and the problem is those spreads can blow out to 800 basis points in a hurry,” Mr. Blumenthal said. “We saw it happen at the height of the crisis in 2008, when those spreads blew out to 1,500 basis points.”
Thus, just as the five-plus-year QE program is creating the opportunity in high yield, the Fed policy also represents the biggest risk to the category.
“When there's one big buyer that everyone knows is going away, you run the risk of a bunch of big trades getting in your way as you're trying to get out of high yield,” Mr. Blumenthal said.
With that in mind, he suggested one of two ways to tap into the high-yield bond market.
“A conservative way would be to play the next announcement that the Fed plans to taper by investing in a high-yield mutual fund or ETF and then plan to move that allocation into Treasury bonds when [high-yield bond] prices start declining,” Mr. Blumenthal said. “And you can tactically trade in and out because high-yield price momentum tends to trade very predictably.”
A more aggressive approach would be to wait until we get closer to the yield and price movement and then invest in an exchange-traded fund that provides short exposure to Treasury bonds, such as the ProShares UltraShort 20+ Year Treasury (TBT), Mr. Blumenthal said.
“I wouldn't put that TBT trade on today, but that will be a way to really capitalize on the movement,” he said. “I think the 10-year Treasury [now at 2.5%] is on its way to 3%, and will be north of 5% inside three to five years.”
Another factor to consider regarding exposure to high-yield bonds is that ETFs generally provide more conservative exposure to the asset class, compared with mutual funds.
In addition to being less expensive than mutual funds, ETFs tend to keep high-yield exposure in the double-B rated range, which isn't considered extreme credit risk.
“We're finding more and more single-B and triple-C rated bonds showing up in the actively managed high-yield mutual funds,” Mr. Rosenbluth said. “A lot of mutual fund managers are going out on the credit spectrum for a chance for greater yield, which is something you don't get in the ETF space unless they change the benchmark.”
Among ETFs, Mr. Rosenbluth likes the iShares iBoxx High Yield Corporate Bond ETF (HYG). And among mutual funds, he likes the Ivy High Income Fund (WHIAX).