Strategy Time... (a revisit to high yield corp bonds)

High yield bonds offer investors attractive income in the current environment, with an average yield of more than 600 basis points greater than the yield on government bonds.

So, why is it important for investors to include an allocation to high yield bonds in their portfolio?

1. Enhanced Diversification - High yield bonds are often considered a distinct asset class, as they involve different return characteristics and have a lower correlation to traditional asset classes such as Government bonds and equity. For this reason, adding high yield bonds can increase portfolio diversification, and potentially reduce risk and enhance returns.

2. Attractive Income Potential - With interest rates at low levels, most investors cannot generate the income they require by investing in government bonds alone. Generally speaking, high yield bonds pay higher interest rates than investment-grade and government bonds to help compensate investors for the additional risks of investing in lower quality bonds. Over the life of a bond, those higher coupons provide a higher rate of return than higher quality (investment grade) bonds.

High yield bonds offer investors attractive income in the current environment, with an average yield of more than 600 basis points greater than the yield on government bonds.

3. Capital Growth Potential - In a recovering economy, companies who issue high yield bonds can see their debt rating upgraded due to improved cash flow, offering investors the potential for capital appreciation from the associated increase in the bond’s price. Historically, high yield bonds have tended to provide equity-like returns, but with much lower volatility – a characteristic that many investors are currently looking for.

4. Less Sensitivity to Interest Rates - High yield bonds tend to be less sensitive to interest rate fluctuations than most fixed income securities, primarily because they carry a higher coupon and have terms of 10 years or less. In addition, high yield bond prices react more to credit spreads and changes in credit quality than interest rates.

What’s the outlook for high yield bonds?

We believe conditions remain extremely favorable for high yield bonds. Weak demand, particularly from consumers is providing an environment of slow but positive economic growth, low interest rates and low inflation. Corporations, having cut costs and delevered balance sheets during the credit crisis, are showing strong profit growth but only marginal revenue growth. As a result, leverage across the corporate sector remains low, and cash has been building to record levels. Credit quality, as measured by balance sheet strength is at record levels and corporate default rates are headed towards new lows.

With yields on traditional income producing investments at record lows, investors are increasingly looking to high yield bonds to provide steady, sustainable cash flows. In addition, many investors have been unnerved by the extreme volatility of equities in recent years, with high yield bonds offering an attractive, less volatile alternative. As a result, flows into the sector from both institutional and retail investors continue to grow, putting downward pressure on spreads.

How are we incorporating them in our client’s portfolios? (A study)

All portfolios reflect the clients individual risk tolerances, goals and requirements, so we sit with each and build out a strategy on a case-by-case basis. However, from a macro view, parts of client’s portfolios that are focused around a 100% equity mandate have benefitted greatly from scaling back (say 25%) and reallocating to High Yield.

The chart below shows the 15 year return of the S&P 500 along with the 15 year return on the US High Yield Index. Interestingly, High Yield outperformed by over 8%, but with substantially less volatility during that period.

For clients scaling back to a 25% High Yield / 75% Equity portfolio - the average annual return bettered the 100% Equity portfolio by around 2.2%. ***And it did so at 25% less volatility.

How does one best invest in this asset class?

It is important to view High Yield Corporate Bonds in a similar risk category as equities. (I commonly refer to them as a “stock in bonds clothing”.) So, I do not look to include them in the Fixed Income portion of client’s portfolio profiles, but rather towards the overall equity portion.

There are a number of ways to participate in High Yield: directly buying the bonds from the issuer, buying the index through various ETFs, or buying units of a High Yield fund. All 3 are great ways, but are unique and dependant on the requirements of the client. **Questions such as Cost, Liquidity, Diversity (market and sector), and Manager Risk are all part of the decision process.

Here are some examples:

iShares IBOXX Hi Yield Index ETF (HYG)

Costs 0.5% MER
The 3 year return 9.36%
The 3 year index return was 10.41%
Small tracking error for this ETF
Current Yield: 8.17%

Marret High Yield Fund (MHY.UN)

Barry Allen – Fund Manager
Costs 1% MER
Average duration – 3 yrs.
Since inception (June 2009) return 10.51%
Current Yield: 7.34%


The High Yield market in Canada is quite small, with most new issue allocations going towards the institutional investor, so looking towards a managed or indexing approach would provide access to much broader markets for the individual investor.

As always, contact your investment advisor to see if this asset class is an appropriate fit in your current portfolio.

Best Regards and Safe Investing.

Eric.

Market Update.... Emphasis on the Pro's not the Con's

So here we are...

It's been entirely too long to go without an entry to my blog. Albeit, my weekly Market Watch newsletter has refocused my attention, it is now time to place some very serious thoughts into perspective.

I've lost all craving for houmous, grape leaves and spanikopita. Probably for ever...

Here's a summary of the expected Euro plan for Greece:

1. Greek bondholders will “voluntarily” write down the value of Greek debt by 50% which will help reduce Greece’s debt load from 150% of GDP down to 120% by 2020.

2. The European Financial Stability Fund (EFSF) will be expanded to 1 trillion euros from the current 440 billion euros through a combination of additional funding from the IMF and possibly a capital injection by China and/or other nations.

3. European banks will be recapitalized to offset the impact of the haircut on Greek bonds.
As encouraging as this European agreement is in principle, it is clearly just the first step in a multi-step program to resolve the European debt crisis.

Despite the significant stock market rally, equities remain the favoured asset class versus bonds. That said, we expect equity market volatility to continue and recommend profit taking to lock in recent short term gains. For buyers building longer term portfolio positions, we expect the market will provide yet another lower entry point so there is no rush to buy at current levels.
One of a few exceptions would be gold which has pulled back almost US$200/oz. since the highs reached in August. Both gold bullion and gold equities should perform well in the current environment.

Commodity cyclicals and industrial stocks offer the most upside potential in the event equities rally again, but they also will likely continue to exhibit the greatest volatility.

Many high quality dividend paying stocks at current levels do not offer much capital appreciation potential but will provide investors with the most downside protection if the market retreats, and the steady dividend income generated remains an important component in portfolio total returns.

Given our outlook for an extended period of slow economic growth, whether falling into outright recession in North America or not, equities are expected to trade in a range for the next several years. We are inclined to trim some profits on holdings that have performed well. In turn, emphasizing the need to be more tactical in the current environment, this capital could be selectively rotated into stable names that are more reasonably valued.

We place particular emphasis on the word "selectively" given the fragile situation in Europe and we continue to encourage a focus on larger-cap companies with sound balance sheets.

Stick to your knitting....

There are indications of a Bullish time for equities ahead.... Why?

1. Systematic/mechanical devaluation of the US$

*Global Commodites/Resources priced in USD.

*Forecasting of some substantial falls in commodity prices over the next few years.

*Which will lower Inflation pressures in global Markets.
(I.e. A $10 fall in the price of a barrel of oil would transfer an amount of income equivalent to around 0.5% of world GDP from producers to consumers.)

*Eventually drive resurgence of demand.

*Good for Canadian resource heavy economy which some argue could overheat and (as we've seen in the past) fail to diversify.

2. The death of Defined Benefit Pension Plans.

*Larger institutional money must be reallocated away from risk-free assets towards stronger blue-chip portfolios.

*Equities will benefit from this "refocus" by pension plans and other large institutional players.

3. 100 Years of Expansion and Consolidation Trends.

*As per the chart at the top of this entry, there are very interesting themes that have taken place throughout history of the stockmarkets (in this case, the Dow Jones Industrial Average).

*After expansionary periods in the markets (which last on average 20 years), there are contractions/consolidations that last around 15 years.

*Roughly putting the next 20 year "up" period at a start date of around 2015... (Almost there)

The key of course will be to find ways to continue to navigate the turbulent waters ahead. It is paramount that we tailor our investment policies to reduce volatility and ensure a certain margin of safety is built in, should the macro-economic environment take a turn for the worse.

Best Regards and Safe Investing.