With the shortening of duration, many investors have taken on more credit risk than historical norms. This has created what many describe as a bubble in high yield debt that has the potential to unwind if we start to see an economic slowdown or rush for the exits. A stumble in the stock market could trip up junk bonds and send money fleeing from equities and credit sensitive holdings.
Right now we are still in an uptrend with respect to high yield, bank loans, and convertible bonds which is why I am recommending you hold on to your exposure in these areas. However, I am closely monitoring these high yield sectors for signs of a reversal which would warrant moving a portion of capital back to more quality holdings such as the iShares Investment Grade Corporate Bond ETF (LQD) or the iShares MBS ETF (MBB). These ETFs, along with treasuries, would likely do well in a deflationary environment under the scenarios of a flight to quality.
Another correlation I am monitoring with respect to high yield is the divergence between U.S. high yield corporate debt and emerging market bonds of a similar credit quality. Consider that the iShares High Yield Corporate Bond ETF (HYG) is trading near all-time highs and has a comparable yield to the WisdomTree Emerging Market Corporate Bond ETF (EMCB). However, EMCB is still more than 5% off its high water mark. I expect that this divergence will eventually correct and we could see money flow into emerging markets as fixed-income investors find more value and diversification overseas next year.
Conclusions
Picking the right fixed-income ETF or mutual fund that suits your needs is all about evaluating your risk tolerance and investment objectives. You should do some analysis of top performing funds from previous years and ask yourself how they will perform under certain scenarios. If the Fed decides to speed up or slow down it’s taper agenda, you may have to shift your portfolio to cope with changing dynamics. In addition, it’s important to keep an eye on the health of equity and credit sensitive markets as these will impact the bond market in the coming year ahead.
One actively managed mutual fund that is one of my favorite core holdings is the PIMCO Income Fund (PONDX) which takes a multi-sector approach to specific areas of the bond market that the manager feels will outperform. They have done a fantastic job of managing interest rate risk in 2013 and taking advantage of opportunities (both inside and outside the U.S.) when they are available. This has led to year-to-date returns approaching 4.5%, an effective duration of less than 5 years, and a current 30-day SEC yield of nearly 4%.
In a following series of articles, I will detail my thoughts on equities and alternative investments for income investors in 2014. As you are evaluating your portfolio heading into the new year, make sure that you stay balanced and agile with respect to opportunities and risks that may present themselves. That way you are prepared with a game plan to shift your asset allocation when needed and overcome any obstacles that you may encounter. Here’s to a healthy and wealthy New Year!