February 13, 2018 | by Matthew Pasts, CMT, CEO, BTS Asset Management, Inc.

Playing Defense-Trading Opportunity May Arise as Trends Stabilize

On 2/9/18, BTS sold high yield bond positions and went to cash, based on indicators weakening. In particular, these related to:

• Recent volatility in stocks and steepening of the yield curve
• Interest rates moving higher in a short period of time, creating uncertainty and volatility. Specifically, the 10-year Treasury yield moved from 2.32% to 2.86% over the last three months.

Wage and inflation pressures reflected in the January employment report served as a major catalyst for the correction—which makes sense as we have seen the 10-year Treasury yield break through the 2.6% level and then move over 2.8% in short order.

Bonds relatively resilient but no clear trend yet

In comparison to the recent selloff in stocks, both investment grade and high yield corporate bond markets have been resilient. Yields spreads have widened marginally, and BTS has moved to defensive positioning until the volatility subsides.

This is consistent with our views as expressed in a recent update:

• “If the 10-year Treasury yield holds its recent rise and the yield curve maintains its slope, further increases in the 10-year yield toward 3% likely reflect higher inflation risk. The rates of change of the 10-year and 30-year yields are important. A sharp break higher in either is likely to correlate to more volatility in the stock market.”
• We also pointed out: “A major risk that could unfold in the near term and affect the current trend in risk assets is a sustained tightening of monetary conditions spurred by higher than expected inflation. While we do not expect the primary bull market in risk assets to be de-railed, a long over-due correction of about 10% could occur and open up a trading opportunity.”

Potential paths forward

Looking forward, a stabilization of indicators could present an opportunity to re-enter high yields and collect “coupon.” Although spreads are at historically tight levels of around 300 basis points over comparable government bonds, a 6% yield to maturity may offer decent return potential.

With the economy growing, a gradual rise in interest rates is normal and may suggest that the risk of a flat yield curve is abating (flat and inverted yield curves indicate risks of recession). A default rate of only 2% among high yield issuers reflects the generally strong cash flow coverage position of corporate borrowers.

However, if the 10-year Treasury breaks over 3% toward 3.25% within a month or so, the stock market is likely to again be pressured. Moreover, a quick move of the 10-year yield over 3% could again pressure high yield bonds. A widening of spreads beyond 300 basis points could lead to momentum selling and present an opportunity to trade in at lower prices.

For now, BTS indicators are keeping assets in money market funds. Volatility increases uncertainty, and a trend needs to be established before investing assets back into the high yield market. Risk remains high that spreads will widen if interest rates move above 3% in the near term.

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It should not be assumed that investment decisions made in the future will be profitable or guard against losses, as no particular strategy can guarantee future results or entirely protect against loss of principal. There is no guarantee that the strategies discussed will succeed in all market conditions or are appropriate for every investor.