July 18, 2014 By Steve Blumenthal
“See life as a marvelous unfolding of possibilities and blessings!”
-Author unknown
I’m writing a piece for Forbes about high yield and I’d like to share with you the genesis of the piece (I’ll provide a link for you in next week’s On My Radar). Simply, yields are far too low and companies are finding funding that historically would not be available. A default wave is ahead. It is time to be tactical with your high yield bond exposure.
Similar to the easy money sub-prime mortgage days at the top of the last credit bubble in 2007, the sailing looks safe; however, over the horizon a storm is brewing. Forced by the Fed’s zero interest rate policy into riskier asset classes, investors may be unaware of the risk they have entered into.
The high yield bond market traffic light is flashing red. The positive message here is that another great opportunity will present itself soon.
I share the following in this week’s On My Radar:
- Several Quick Thoughts on the High Yield Bond Market – A Challenging Three Months Ahead
- Equity Tail (Crisis Event) Risk Hedging
- Trade Signals: At Some Point We Will Fight the Fed – 07-16-2014
Several Quick Thoughts on the High Yield Bond Market – A Challenging Three Months Ahead
The current yield on the Barclays U.S. Corporate High Yield Index is just 5.54% (a record low yield). The below chart shows the Barclays U.S. Corporate High Yield Bond Indexes from 2000 to present. The black line is the price of the index only. The blue line shows the total return, which includes both price and yields. The red line shows the yield to worst (similar to the current yield).
Note the orange highlighted box and the decline that took place in the last crisis. Side-stepping most of that decline would have put you in a position to buy in at a lower price and a much higher yield (red arrow).
The goal is to be aware of risk, participate in gains and have a plan in place to protect against the downside. The main objective is to be in a favorable financial position that enables you to take advantage of the higher yields and higher return environment that the next crisis creates.
As noted in the next chart (Seasonality of High Yield Bond Excess Returns), the next three months look challenging.
As a quick aside, yesterday our high yield trend following strategy flashed a sell signal. We tactically moved our clients to cash as we have done with discipline for over 20 plus years. While high yield bond prices tend to trend in a fairly probable way, there are certainly no guarantees we are correct on this trade or any trade for that matter. With current yields so low, coupled with the less favorable seasonal tendencies, I am happy our process signaled a sell. We want gains and we want to protect the downside. Caution is advised.
Finally, it is important to remember that the high yield bond asset class has been an attractive asset class over time. I believe it is appropriate for a “portion” of your clients’ portfolio. How much? You decide based on the needs of your individual clients. I do believe it will remain a favorable asset class for years to come; however, as was the case in 2007/08, it is best not to step in front of an oncoming train. Not sure if this is that train but a train is coming. With yields so low, now is the time to tactically trade the high yield exposure you have in your portfolios.
That’s the gist of the piece I’m going to publish. I’ll share some ideas on how to tactically trade and share a few lessons learned over 20+ years as a high yield tactical trend following strategist. I hope you’ll find the upcoming Forbes piece helpful in your work with your clients. Please reach out to me afterwards if you have any questions.
Source: http://en.wikipedia.org/wiki/Bond_credit_rating
Equity Tail (Crisis Event) Risk Hedging
I believe there is a way you can protect your stock exposure from crash-like events. It requires work and knowledge and/or a relationship with someone with skill in this area. The tools are put and call options on stock indices and I believe that it can be done with little expense over a market cycle.
Such a hedging process is particularly important when the market is richly priced as it today. It is less important, in my view, after a major correction. While equities are an important investment risk to include in most clients’ portfolios, it is often hard for many clients to stay the course. Some form of risk management, in my view, can allow for further growth while meaningfully protecting downside risk and hopefully keeping your client from panic.
Here is a link to a piece titled, Rolling Tail Hedges: The Dynamic Tradeoff between Cost and Potency, by Vineer Bhansali, Ph.D. and PIMCO Managing Director.
There are a couple of key points:
- Hedging has to be a systematic, repeated, asset allocation decision to obtain best long-term benefits.
- Hedge program has to be active and consider pricing levels so efficient rebalancing can be implemented.
We run an always hedging process within one of our equity strategies. Not too dissimilar to what Dr. Bhansali is suggesting in his paper and further in his book. The goal is to own great companies while inexpensively protecting a good portion of the downside that comes at times of major market correction.
Dr. Bhansali’s paper will especially appeal to you if you are a quant geek like me. Overall, the main message here is that the tools exist as do the experts/strategists that can help you build broadly diversified portfolios designed to allow you to participate in the gains in the market while reducing your overall downside risk.
We investors need to take risk but we can be smarter about how we take on that risk and how we combine various risk sets together.
Trade Signals: At Some Point We Will Fight the Fed- 7-16-2014
Click here for a link to Wednesday’s Trade Signals.
Conclusion
I woke up early yesterday morning and set out for a run along the shores of Lake Michigan. The sun was coming up and the lake was still. “Chicago!,” I thought to myself, “I’m in love with Chicago”, as I slowed my pace nearing the Drake Hotel.
I was there to present at the Brookstone Capital Management Annual Conference. Brookstone has a team of 240 independent advisors led by my friend, Dean Zayed. Talk about a human being with mojo. Dean is as humble as he is smart and charismatic. A great combination and his success is a real joy to watch.
The morning run high was soon to be broken. Thursday was an emotionally painful day for me and I’m sure for you as well. The events in both the Ukraine and Israel are tragic. The world seems to be way offside. We humans – what a mess. I prayed for a long time this morning. I prayed for the families, I prayed for hope and I prayed for peace. When I came in to the office today, I noticed an old yellow sticky note on my desk. On it was something I jotted down (I’m not sure when). It said, “See life as a marvelous unfolding of possibilities and blessings”. A nice thought… a marvelous unfolding of possibilities and blessings. I’m going to share it with my kids tonight and try to send some more light to where it is most dark.
Florida is up next with a quant geek’s dream lined up for me at Ned Davis Research. Susan and I are escaping to a quiet hotel near Cape Cod at the end of the month to be followed shortly by a week with our combined six beautiful kids in Stone Harbor, New Jersey. You should see how much fun the dinners are together. I hope you have some vacation plans in your immediate future. Escape to your favorite place, enjoy those you love most and recharge.
Have a wonderful weekend.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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