Junk in the Trunk
“In the past three months, the global recovery, which was not strong to start with, has shown signs of further weakness . . . downside risks continue to loom large, importantly reflecting risks of delayed or insufficient policy action.”
– IMF World Economic Outlook, July 16, 2012
It’s important to recognize that a healthy economy is not dependent on said “policy action.” Rather, the economic landscape today is quite typical of historical experience which suggests that excessive debt is a drag on growth. At the moment, the global economy is tipping toward slower growth and central banks will predictably respond by printing more money. With interest rates already pegged at zero today, money printing acts like a defibrillator for an economy in cardiac arrest. The economy starts beating again and then it fades . . . until policymakers provide it with another “shock.”
But each additional dose of stimulation has less of an impact and eventually wears on the patient. The result is a very sluggish growth trend with brief cyclical upswings followed by bouts of weakness when stimulus wears off. The IMF projects growth in advanced economies to expand by 1.4% this year and 1.9% in 2013, but (bravely) assumes conditions in the euro area improve to meet these targets. Investors should consider what a low growth and low (no) interest rate environment means for expected returns. Here is how asset classes have performed during different ranges of GDP growth from 1980 to today.
The high yield, or “junk” bond market (green bars in the above chart), has historically provided higher returns than stocks (with less risk) when economic growth has been sluggish, as it is today, and as it will likely remain for years ahead. The good folks at PIMCO recently articulated the case for owning high yield in a piece titled, A Closer Look at “Junk” Spreads. More specifically, they take a closer look at a particular segment of the high yield market which we’ve grown quite fond of over the years:
“We believe investors can still benefit from the income potential of the high yield asset class by focusing on the higher quality segment of the market – generally, those rated single-B and higher, secured bonds and short duration bonds . . . Within high-quality high yield, one area that we find attractive, especially in light of available alternatives, is short duration bonds from issuers with relatively attractive credit and liquidity profiles. Given their tendency for lower price volatility than the broader high yield universe and relatively attractive yields, such bonds may appeal to investors with cash on the sidelines.
“Another reason we like short-dated bonds is they can generally trade wider than the spread valuations implied by their credit default swaps (CDS). In other words, short-dated high yield bonds can generally trade at a better discount to the level implied by their default probabilities than longer-dated bonds. . . . . Why does this situation exist? Generally, the longer the maturity, the greater the compensation or spread investors demand per year for buying or selling protection on the credit, resulting in an upward sloping, or steep CDS spread curve. Similarly, the yields on high yield cash bonds also increase with maturity. However, when it comes to Treasuries, the short end of the yield curve is anchored by the Fed’s near-zero interest rates, creating a somewhat steeper Treasury bond curve compared to the high yield curve; this generally results in higher spreads for shorter maturity high yield bonds. Consequently, investors looking for that extra spread can potentially find it in the two- to four-year part of the high yield market without having to reach out in terms of duration.”
For our part, we still see tremendous value in short-maturity, high-quality, high yield bonds and continue to focus on lesser-known, less liquid issues – a sandbox too small for the PIMCO’s of the world to play in, which creates even more opportunity for additional alpha generation. The Broyhill Opportunistic Fixed Income Portfolio, for example, has an average maturity of under two years and yields roughly double digits. Although the focus is predominantly on return of capital rather than return on capital, the strategy has generated handsome gains since inception with a fraction of the stock market’s volatility. Let us know if you’d like some junk in your trunk.