Thursday, July 18, 2013

Confounding Predictions, Investors Flock Back to High Yield Bonds


I just returned from a meeting with an investment committee, where I was reviewing the performance of their account.

With almost 40% of their portfolio invested in bonds, a good portion of the meeting was devoted to the future prospects for fixed income.

It is hard to find anyone these days who does not think interest rates are not headed higher.  Most of the discussion relates to the timing, and ultimate level of rates, rather than the direction.

Any time you get such a broad consensus on any asset class - stocks, bonds, commodities, etc. - you should be worried.  Strategist Ned Davis has preached the axiom "Be Wary of the Crowd at Extremes", meaning when everyone "knows" something is going to happen the reverse usually occurs.

And so it has the case with bonds over the last month.

US Treasury notes, for example, hit 2.74% on July 5 after the strong employment report was released.  Since then rates have moved steadily lower again, and the 10-year US Treasury now yields 2.54%, or roughly equal to where rates stood a month ago.

The real move, however, has been in the high yield market, where investor appetite for yield has returned with a vengeance.

Here's what an article in this morning's Financial Times wrote:

Investors are returning to the riskiest corporate bonds in the US debt markets in numbers, shrugging off recent sharp losses and record outflows from the securities in June.

Average yields on junk debt, which moves inversely to prices, have tumbled sharply over the last week - nearly 60 basis points - and are falling towards the 6 per cent mark. That level has become a key psychological mark for the securities sold by companies with higher probability of default.

The article goes on to note that US high yield mutual funds have saw a $12.3 billion inflow last week, which was the second consecutive week of positive inflows after $9.1 billion was redeemed in June.