Recent returns from public market fixed income have not been attractive. For all of 2013, the Barclays Capital U.S. Aggregate Index returned -2.02%. For the 5-year period ending in 2013 the average annual return was a more comforting 4.44%, just a tad below the 10-year average annual return of 4.55%. One reason for the positive returns over the last decade is falling rates. We started 2004 with a 10-year U.S. Treasury yield of 4.15% and at the end of 2013 it was down to 3.03% (that’s up from 1.97% at the beginning of 2012). Bond yields and prices move inversely to each other, which is why returns have been under pressure recently.
High yield bonds have been one of the few bright spots. For 2013 high yield bonds were up 7.44%, which has attracted a lot of attention and helped to broaden the market appeal for a category that was shunned just a few years ago. In 2008 high yield bonds were down 26.16%, causing many amateur and professional investors to learn some lessons the hard way. That was when the “high yield” euphemism of late was rejected by many for the more derogatory term of “junk bonds” (anyone remember Michael Milken?)
Clients that attend our Quarterly Market Review presentations have become accustomed to hearing me explain why we don’t invest in high yield bonds. The basic idea is this: we avoid multiple sectors of the fixed income market that can have extreme volatility; that includes high yield, bank loan/floating rate, and longer-dated U.S. Treasurys. The rationale is simple enough—if we wanted that kind of volatility in our portfolios we feel the assets should just go into equities, where the risk/return ratio has been more favorable.
The unique risks of investing in high yield bonds are two-fold. The obvious risk is the risk of default, which can be especially pronounced if you hold just a few individual bond issues. A default might not be a total loss, but it means you don’t get some or all of your money back when the bond matures. If you invest in a diversified vehicle, like a mutual fund, the damage from defaults might not be that bad. But the other risk, of extreme price fluctuation, is unavoidable. When investors’ sentiment turns negative, they want to sell riskier bonds and all that selling pressure can hit the market at once. Bonds with some risk that they won’t pay back the investors at maturity are called “credit bonds”. And when the market for credit bonds dries up we have a “credit crisis”. In 2008 we experienced a severe credit crisis, which is why high yield bonds did so poorly even though the more credit-worthy Barclays Capital U.S. Aggregate Index returned a comfortable 5.24%.
The risk in high yield bonds may be growing. Investor demand for yield has created a market for what some call the “dark corners” of the bond market. Bonds with low ratings are being packaged into Exchange Traded Products (ETFs, CEFs, etc.) that may amplify the risks for everyone. This may remind you of the problems from just a few years ago when huge pools of poor quality mortgages and other risky investments were pooled into securities that supposedly had less risk than their constituent parts. This is a bit different—these ETPs do disclose the risks of the underlying portfolio if people want to do the research—but the problem is that this rapidly growing market may one day face pressures not seen in 2008 because many more investors may be expecting to sell when times get tough again. In other words, the next time we get even a small economic shock, the rush to the exits by these investors in high yield bonds could result in a bigger price drop and could even precipitate an economic crisis that would otherwise be avoidable.
We focus our public market fixed income strategy on highly liquid, investment grade issues using diversified ETPs or mutual funds. Investment grade refers to a credit rating of AAA, AA, A, or BBB. Speculative grade (high yield) starts at BB and goes down from there. The goal of our strategy is to provide downside protection and liquidity; our clients need liquidity so we can sell fixed income after a stock market dip to buy more stocks, our clients need liquidity because they might be taking distributions from their portfolios for living expenses, and our clients need liquidity because many of them regularly pull assets out of the public markets to buy private market investments.
Market timing isn’t the answer to avoiding bond risks. Consider this, Standard and Poor’s reported that in 2008, the year public market high yield bonds lost 26.16%, only 3.61% of all speculative-grade fixed income actually defaulted. The price dropped because investors were suddenly worried about the future, not because of defaults. This meant that an investor in high yield wishing to protect themselves from what happened later in 2009 (when the default rate jumped to 9.6%) would have to sell at a large loss before defaults ticked up.
Private market fixed income investing can offer an opportunity for diversification and increased returns. It might not be right for all investors, but private market fixed income has different risks than the high yield public market bonds we’re so worried about, and can therefore offer investors a different risk/return profile. Private market fixed income is by definition not a daily priced asset; it should only be used by investors who don’t expect liquidity. Instead, the investor should be concerned about default risk, and if the return for the expected default risk is better than can be found with a publicly traded bond of the same yield and time frame then the private market investment can be more attractive. This allows the investor to keep more funds in the lower risk public market fixed income investments that can be sold when needed.
At BIP we sincerely appreciate the trust and confidence you have placed in us and we feel a great duty to use the most rational and scientific approach to investing that is available. Many trends will come and go in the investment world, and while we will examine each new idea with an open mind, we strive to avoid the hype and emotion that can distract us from our mission.
This communication contains general investing information that is not suitable for everyone and is subject to change without notice. Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass. Any reference to market or index performance is for informational purposes and does not reflect the deduction of fees and does not represent actual portfolios. The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security. Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Yield curve data from Federal Reserve. Barclays Capital U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities. High Yield represented by Barclays Capital U.S. Corporate High Yield Index, which measures USD-denominated, non-investment grade corporate securities. Default rates are from the Standard & Poor’s. Private market investments are not discretionary and the BIP Personal Wealth Advisor will discuss the risks involved with each client. Private market investment returns are highly variable and unpredictable, and are only allowed under Federal law for Qualified and Accredited investors. The risks of owning private investments include the risk of complete loss of principal, illiquidity, lack of marketability, and dilution from future investors.