Confused about the bond market? Who wouldn’t be? Treasury yields have been falling, typically an indicator of a weakening economy. Yet bonds issued by risky companies have been rising sharply, which usually happens when the economic outlook is bright.
David Kotok, chief investment officer at Cumberland Advisors, says he hasn’t seen a market as perplexing as today’s in his nearly 50-year investment career. He cites a variety of reasons for the current contradictions: trade tensions between the U.S. and China, changes in central banks’ plans for their bond-buying programs, the Federal Reserve’s decision to pause its interest-rate increases, ongoing deterioration in corporate credit quality, and conflicting signals from financial markets.
“I don’t ever recall conditions like these,” says Kotok, who co-founded Cumberland in 1973.
The good news for investors is that the confusion creates opportunity—if you know where to look and are willing to take a point of view about the direction of interest rates and the outlook for bond issuers. It also helps not to panic about the recent inversion of the U.S. Treasury yield curve, when the benchmark 10-year Treasury yield fell below the yield on the three-month bill. Yield-curve inversions are widely considered harbingers of a recession within the next 18 months, although last month’s inversion lasted barely a week.
Even if a countdown to recession has begun, some bond bulls see room for yields to fall and prices to rally further thanks to the Fed’s newly cautious stance on interest rates. When the central bank indicated in February that it was pausing its interest-rate hikes and planning to stop shrinking its balance sheet, it took the pressure off the bond market, says Bob Michele, chief investment officer and head of fixed income at J.P. Morgan Asset Management. As a result, his team has been buying relatively risky debt, including emerging-market debt denominated in foreign currencies.
It is also adding high-yield bonds and the so-called BBBs, or corporate bonds rated triple-B, three or fewer levels above junk. “We like every bond out there,” Michele says.
The problem is that other investors seem to like bonds, too. High-yield and investment-grade bond markets have returned 7.5% and 4.7%, respectively, year to date through April 2. The bonds with the highest credit quality have outperformed their riskier peers in both markets.
There is a good reason for that. If the U.S. is heading for a recession, companies that issue lower-rated bonds could have more trouble making their payments. But if the U.S. manages to avoid a recession for months—or even years—the best opportunities could lie in the scariest corners of the bond market.
Jim Schaeffer, deputy chief investment officer of Aegon Asset Management, says his firm is buying riskier bonds. In the investment-grade bond market, that means BBBs. They yield 4%, above the broader investment-grade bond market’s 3.7%, according to Bloomberg Barclays Indices.
In the high-yield market, Schaeffer is buying cheap bonds rated B+, B, and B-, between four and six levels below investment-grade. Those bonds yielded 7.4% as of April 2, above the broader high-yield market’s 6.3% yield.
Schaeffer also holds some CCCs, bonds with the credit rating nearest default. But he’s taking extra care. While these bonds yield nearly 7.5%, some of the companies end up defaulting, making individual selection critical.
The Fidelity Advisor High Income Advantage fund (FAHDX) and the Loomis Sayles High Income Opportunities fund (LSIOX) both take more risk than the average high-yield bond fund, and should allow investors to play this theme. Both are rated five stars by Morningstar.
Not everyone has the stomach for that kind of risk, however. Timing a recession is a tricky business, and bond markets are relatively illiquid, which can mean big losses if the turn is missed. Cumberland's Kotok, for one, warns against playing in the riskiest parts of the bond market. “People who are chasing yield in high-yield markets are playing with fire,” he says. “Sooner or later, there’s a price to be paid for doing so.”
Instead, Kotok recommends investors take a two-pronged approach: First, he says, buy long-dated municipal bonds with high credit ratings to collect tax-free yield, since they have been inexpensive recently compared with Treasuries.
On April 2, such long-dated muni bonds yielded 3.1% versus the 2.9% yield available on a 30-year Treasury. Financial markets indicate that traders expect the Fed to pause its rate increases for this year, and cut rates after that. If the market is right, the long-term muni bet should pay off because long-duration investments benefit most when interest rates fall.
The Vanguard Long-Term Tax-Exempt fund (VWLTX) is a solid choice among funds that own long-term munis.
Kotok advises investors to pair long-dated munis or muni funds with floating-rate munis to partially offset the risk of rising rates. Or, he said, investors can pair such investments with simple government money-market funds as yields above 2% can be found at most online brokers.
That’s the silver lining to the bond market’s current conundrum. Recession or no, there are short-term, safe assets that yield more than 2%, and ways to lock in higher yields with some downside protection.
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