Reach For High Yield Continues: ‘Fire and Ice’ Strategy

Reaching For High Yield by David Merkel, CFA of Aleph Blog

15 months ago I wrote a piece called Expensive High Yield – II.  High yield is still expensive.  I won’t post all of the regressions, but I have re-run them.  The results are largely the same as before.  Yields are low, and spreads are overly tight for everything except CCC bonds.

Much of this is the result of the Fed’s low fed funds rate and quantitative easing, which forces investors to take more risk.  Another aspect is the strong equity market.

Also, CCC bonds offering opportunity may not adjust for the loosening of covenant protections.  There is a tendency for investors to try to maintain yield levels while letting quality & covenants sag.  In a low interest environment, with more and more people retiring, there is a growing desire for the simplicity of yield.

My conclusion last time was this:

All of the corporate bond market is expensive relative to history, perhaps excluding CCC bonds.  That doesn’t mean it can’t get more expensive, particularly if stocks continue to move upward.   But this won’t last for more than two years; the signs of speculation are here, and that should make us cautious.

As a result, I am investing my bond strategy cautiously now.  What little yield I get comes from emerging market sovereigns.  Credit risk from corporates is small.

Well, I blew it with emerging markets; what a kick in the teeth.  I would have been better off in high yield.  As it is, for me and my bond clients, the strategy is Fire and Ice.  20% long Treasuries for deflation, 80% short credit instruments for inflation.  So far, so good.

Be wary in this environment.  So many are reaching for yield amid a weak economy with yields that are low relative to past trends.  But also be aware that a rising stock market can support the corporate bond market.  That has worked for the last two years, but it can’t work forever.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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