Investors continue to look lower on the credit quality spectrum in their search for yield. Investors purchased $3.42 billion in high yield U.S. mutual funds and ETFs in the first quarter compared to $1.76 billion a year ago. The heavy demand by investors has allowed issuers to lower the yields they offer and has reduced the covenants attached to the securities that protect investors. The yield spread between triple C rated bonds and Treasuries (meaning the difference between their return) is at its lowest level since July 2007, before the financial crisis.
RWM advocates a total return approach to investing as opposed to an income approach. The total return of an investment is made up of both its interest or dividends and its capital appreciation. By focusing on total return it allows a portfolio to be well diversified. Stocks are used for their long term growth, while fixed income is used to preserve the capital of the portfolio.
By focusing strictly on yield an investor in the current environment is forced to move a heavier allocation of their portfolio to high yield bonds, which move closer in line with equities. The correlation of high yield bonds measured by the B of A Merrill Lynch High Yield bond index with US stocks as measured by the Russell 3000 index is 0.60; meaning more often than not the two asset classes move up or down together. This compares to -0.07 between US stocks and Treasurys, representing high quality bonds. The negative correlation means that the two investments typically move in opposite directions of each other. Thus, the diversification benefit seen from including bonds in a portfolio is heavily reduced with a heavier weight to high yield bonds. They also have a volatility level that is close to double that of Treasury bonds, which reduces the capital preservation impact that is provided by higher quality bonds. In addition, the recent decrease in yield spreads compared to Treasurys and weakening covenants point to the investments becoming even more risky as investors are being provided with less financial reward and less protection for taking on these positions.
High quality bonds have shown their worth as safe havens in times of market distress. With the crash of the internet bubble at the turn of the century stocks fell 44.1% from September 2000 to September 2002. At the same time Treasurys rose 24.8%, while high yield bonds sank 9.5%. More recently, from October 2007 through February 2009, stocks plunged 50.3% as a result of the financial crisis. Meanwhile, US Treasurys rose 14.2%, but high yield bonds fell 26.1%. See the below chart which shows the performance of Treasury bonds, high-yield bonds, and stocks from October 2007 through February 2009:
When investors focus on income and move their holdings to focus on higher yielding, lower credit quality, fixed income they are exposing their portfolio to greater risk. They increase the volatility of their portfolio and reduce the degree of diversification; removing the counterbalance higher quality fixed income holdings can provide. By focusing on the total return of a portfolio with capital appreciation as well as yield it provides a more stable portfolio that will provide a better chance for an investor to meet their investment goals.
Index Performance March YTD Trl 1 yr.
US Stock (Russell 3000) 0.53% 1.97% 22.61%
Foreign Stock (FTSE AW ex US) 0.40% 0.57% 12.81%
Total US Bond Mkt. (BarCap Aggregate) -0.17% 1.84% -0.10%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) -0.29% 0.25% -0.03%
Municipal Bonds (BarCap 1-10yr Muni) -0.37% 1.60% 0.78%
Cash (ML 3Month T-Bill) 0.00% 0.01% 0.07%
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