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Macro Themes And The Implications: Time To Pay Attention To U.S. High Yield Bonds

By Dr. Chenjiazi Zhong Key Macro Themes and the Implications Low inflation : Inflation is low but it does not mean inflation is zero. The slow growth in global economy keeps inflation subdued even as CPI slowly rises. Global policy divergence : Fed continues to normalize slowly as other central banks pursue stimulus policies. Investors should expect yields to rise modestly. Supply-side weakness : Across developed countries, the low productivity and growth in labor force will ultimately cap longer-dated yields. Strength in U.S. economy : U.S. economy remains resilient; recession risks are being overpriced for 2016, which indicates a good environment for high yield bond. Gradual recovery in Europe : The expansion in Europe is on track; monetary policy is a key factor that will support EU stocks and credit markets. Japan – beyond Abenomics : The economic risk in Japan is becoming more binary; the asset returns will be more geared to fiscal response. Emerging markets rebalancing : The stats of emerging markets implies that the environment is stabilizing and the valuations are undemanding. The short-term risks exist but investors can expect the conditions will improve in 2016. China in transition : That China is shifting from resources to services will continue to weigh on global trade. U.S. High Yield Bonds In an environment of full valuation, fragile investor sentiment, favorable relative valuations of credit over equity, slow but positive growth with limited recession risk that is priced in, high yield credit that offers equity-like returns is an attractive proxy for stocks. U.S. High yield credit spreads widened the most since 2011. U.S. high yield bonds offer lower volatility than equities due to their coupon income. In down markets, a larger coupon for high yield bonds helps to offset market declines; in up markets, high yield bonds usually correlate to rising equities. Moreover, high yield bonds are generally not impacted by modest rise in interest rates; spreads are more a reflection of market expectations for future default rates rather than expectations for higher interest rates. Furthermore, high yield bonds managers charge lower fees as compared to the hedge funds specializing in distressed debt. Despite U.S. high yield bonds offer equity-like return, investors need to adjust or discount the asset class for its potential for downside losses, liquidity constraints, sector risks, and other realities: The high yield bonds market is characterized by asymmetric risk whereby the potential for downside losses outweighs upside capital appreciation. Asymmetric risk exposure is a situation in which the potential gains and losses on an investment are uneven. The high yield bonds are traded over the counter, which highly depends on dealer capital. Additionally, the majority of high yield bonds do not trade on a daily basis, which means there may be a significant difference between trade prices and broker quotes. Independent fundamental analysis is paramount. The market generally anticipates upgrades and downgrades long before the actual rating changes. The difficulty in estimating defaults is defaults are not correlated to the severity of recessions. For instance, the 2008-2009 period was not the worst for defaults but it was dramatic to other asset classes. The key to long-term success in investing in high yield bonds is managing credit risk, avoiding dangerous concentrations and minimizing defaults in the portfolio. In addition, in harvesting carry across extended credit markets, security selectivity becomes even more crucial . Investors shall stay engaged, know the securities; do not be afraid of sentiment. The increase in volatility is creating numerous opportunities for fundamental, bottom-up investors. With more movement in the market, there is a wider range of possible outcomes, some of them lost, but some of them gained. While the downside increases, so does the upside. As with any investment, the riskier it is, the greater the possible return is. Furthermore, a contrarian stance, backed by a comprehensive understanding of companies’ long-term fundamental prospects, will provide a strong foundation to withstand as well as profit from a world of rising volatility.

Real Risk Taking Will Not Return Until The Fed Flip-Flops

In a strong bull market, higher volatility stocks tend to outperform lower volatility stocks. The PowerShares S&P 500 High Beta (NYSEARCA: SPHB ):iShares USA Minimum Volatility (NYSEARCA: USMV ) price ratio demonstrates how the bull market in equities has been giving way since the highs in the Dow and the S&P 500 one year ago (May 2015). Similarly, in a strong bull market, growth-oriented assets tend to outperform value-oriented holdings. Instead, the iShares Core Growth (NYSEARCA: IUSG ):Vanguard Value (NYSEARCA: VTV ) price ratio illustrates a shift in preference from higher-flying growth securities to “safer” value stocks. The hallmark of bullishness, indiscriminate risk taking, is no longer present in equities. It has been steadily eroding in bonds as well. Take a look at the SPDR High Yield Bond (NYSEARCA: JNK ):iShares 7-10 Year Treasury (NYSEARCA: IEF ) price ratio. The remarkable rally off of the February lows offered some “hopium” that the worst is over for junk debt. On the other hand, the long-term trend toward pursuing safety in treasuries as well as the likelihood of “sell in May” defensive posturing does not favor yield seeking speculation going forward. Perhaps risk taking will return in a meaningful manner soon. I doubt it. Valuation extremes would need to become valuation bargains or, at the very least, the Federal Reserve would need to expand its balance sheet (QE/QE-like activity) yet again. Low borrowing rates alone cannot do the trick when corporate earnings (EBITDA) are deteriorating, revenue is softening and the year-over-year percentage growth of net debt is exploding. Consider the following chart from the Financial Times. Non-financial corporations found themselves leveraged to the hilt in 2000 and again in 2007. Bear market retreats of 50%-plus in stocks occurred shortly thereafter. Why should investors believe that this time is different? The corporate debt balloon is going to be a problem even if central banks perpetually support asset prices through direct purchases and/or rate manipulating schemes. Ten years ago, companies carried $4.6 trillion in outstanding debt. Today? We’re looking at $8.2 trillion. The annualized growth rate of that debt far exceeds the growth rate of profitability or sales. Worse yet, HALF of the $8.2 trillion in corporate bonds is set to mature over the next five years. The implication? Any recession in the next five years will see the vast majority of corporations issuing new debt in an environment where their coupons will be at higher yields and their total total debts will be more difficult to service. Think the resilient U.S. consumer can magically make the problem go away? Fat chance. Since 2001, consumers have only maintained respective living standards by borrowing more in credit to make up for the shortfall in disposable personal income. Take a good hard look at the chart below and ask yourself, “Can this possibly end well? How long can households spend more than they take home before the caca hits the fan once again?” Click to enlarge Can catastrophe be averted? Anything’s possible. Heck, the U.S could experience a remarkable renaissance of high paying careers. It is more probable, unfortunately, that the working-aged population will grow at a faster clip than jobs themselves. There have been 14 million new jobs created (mostly low-paying) since the end of the Great Recession, yet 17 million people entered the labor force in the same period. Not enough jobs. Not enough high-paying employment. And too much household borrowing to make up the difference. Click to enlarge If corporations are getting closer to retrenchment — voluntary or involuntary deleveraging — there will be less money spent on stock buybacks . That would be a problem for the stock market. If households are getting closer to retrenchment — voluntary or involuntary deleveraging — the reduction in consumption would be problematic for equities as well. Brick-and-mortar retailer woe may largely be attributable to online retailer cheer, though some of the troubles are related to consumer spending. Bottom line? Riskier assets are unlikely to gain significant ground in the near-term. An investor would be wise to maintain a defensive posture until valuations improve dramatically or the Federal Reserve flip-flops, ultimately announcing plans to expand its balance sheet once more. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.