For those who have owned high yield bonds and/or emerging market bonds in their portfolios over the last several years, congratulations! Don’t think you own these types of bonds? Then keep reading!
As of September 30, 2017, high yield and emerging market bonds have enjoyed relatively strong performance and have enjoyed 5-year annualized returns of 6.36% (Bloomberg Barclays U.S. Corporate High Yield), 4.41% (Bloomberg EM USD Aggregate index) and 6.63% (Bloomberg Barclays Emerging Market High Yield), compared to the 10-year U.S. Treasury bond which has enjoyed a 1.52% 5-year annual return.1 A quick side note, these index returns are hard to duplicate due to liquidity and the nature of bond trading and thus ETFs that track them tend to have lower returns of ~50-100 bps. With junk bonds performing so well over the last 8 years, and remembering that bond prices and bond yields generally have an inverse relationship, it makes sense then that the chart below shows U.S. high yield (junk) bond yields falling to historically low levels.
For those who want it all, here is a chart of Emerging Market high yield bonds. They too share extremely low yields based on historical ranges.
The question now is, where will the yields, and the prices of these bonds, go from here? Looking at these charts, is it more likely these yields will fall further or will rise? Note that the yield of the 10-year U.S. Treasury bond is hovering just under 2.5% and thus the spread between “safe” bonds and “junk” bonds is only ~2.5%. Are you getting paid enough to justify the risks of junk and emerging market bonds if you are only earning ~2.5% over the “risk-free” U.S. Treasury? Yes, the yields can stay at current levels for extended periods of time. But when they do rise, what will be the effect on your portfolio?
In the 2007-09 global equity bear market, note these bonds correlated with equities and the yields more than tripled. The prices of these bonds were crushed. Now that you can see these types of bonds have more equity like characteristics, it is time to ask what is in your bond portfolio or mutual fund? Is your bond manager using these types of bonds to “diversify” from equities and to reduce volatility? Buyer beware!
If your yield is substantively higher than the 10-Year Treasury, then you are likely taking on more equity like risk than more traditional bond risks. Look under the hood of your 529, target date funds and other bond portfolios. Ask what your exposure is. Large gains can be followed by large losses and we just want to point out some obvious risks in some not so obvious places.
We have been enjoying the second longest equity bull market in history. It might go on for years. Or not. After years of stock and bond gains, now is the time to look at your portfolios for unnecessary risks. As the chart below shows, all asset classes undergo periods of failure. Adjusting after they happen makes no sense as it will be too late. For those worried about capital gains, is it better to pay tax on some profit or risk giving back all the profit? Now is the time to rebalance! As you go into your year-end manager reviews, consider growth strategies that have built-in, rules-based defensive disciplines. It will be a much better outcome than waiting for the bars below to come to life.
This article was contributed by the team at Beaumont Capital Management, a participant in the ETF Strategist Channel.
Source: Bloomberg; Indices performance represented by (in same order as listed above): Bloomberg Barclays U.S. Corporate High Yield Index; Hard Currency (USD Denominated): Bloomberg Barclays EM USD Aggregate Index; Local Currency: Bloomberg Barclays EM Local Currency Government Index; EM High Yield to match chart below: Bloomberg Barclays Emerging Market High Yield Index; Bloomberg Barclays U.S. Government 10 Year Term Index.
Source: Global Asset Allocation (Chapter 3) via mebfaber.com, Meb Faber, March 6, 2015. Bloomberg for the period 1973-2016. The data shown for Convertible Bonds, Preferred stock, High Yield Bonds and MLPs is sourced by Bloomberg. They use the same end date as the rest of the asset classes (12/31/16), but have different starting dates due to the fact the indices for these asset classes did not exist in 1973. Convertible bonds is for the time period starting on 6/17/1986, Preferred stock data starts 9/9/2003 and the MLP data begins 12/21/1995. The returns shown are “Nominal Returns” for the time period specified. For more information on what each asset class performance is represented by, please reference the disclosure pages. “EAFE” represents the regions of Europe, Australasia and Far East. Past performance is no guarantee of future results. An investment cannot be made directly in an index. Asset class performance is represented by the following: U.S. Large Cap – S&P 500; U.S. Small Cap – French Fama Small Cap; Foreign Developed – MSCI EAFE; Foreign Emerging – MSCI EEM; Corporate Bonds – Dow Jones Corporate; T-Bills – U.S. Bills; 10 Year Bonds – U.S. 10-year bonds; 30 Year Bonds – U.S. 30-year bonds; 10 Year Foreign Bonds – Foreign 10-year bonds; High Yield – iBoxx Liquid High Yield; Convertible Bonds – Vanguard Convertible Securities Fund; Preferred Stocks – S&P Preferred Stock; MLPs – Alerian MLP; REITs – NAREIT; Commodities – GSCI; Gold – GFD.
Copyright © 2017 Beaumont Financial Partners, LLC. All rights reserved.
This material is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor should it be construed as financial or investment advice. The information presented in this report is based on data obtained from third party sources. Although it is believed to be accurate, no representation or warranty is made as to its accuracy or completeness.
Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. As with all investments, there are associated inherent risks. An investment cannot be made directly in an index.
Fixed Income investments are subject to inflationary, credit, market and interest rate risks.
The views and opinions expressed throughout this article are those of our Portfolio Manager as of October 2017. The opinions and outlooks may change over time with changing market conditions or other relevant variables.
Beaumont Financial Partners, LLC DBA Beaumont Capital Management, 250 1st Avenue, Suite 101, Needham, MA 02494, (844) 401-7699