November 20, 2018 | by Matthew Pasts, CMT, CEO, BTS Asset Management, Inc.

Why Be Opportunistic During High-Yield Bond Market Volatility?

In early October, our investment models prompted a rotation out of high-yield bonds in our flagship tactical fixed-income strategy.

Then, as risk-asset prices moved upward from October lows, significant support levels were met. A week into November, our investment models signaled the emergence of a possible new intermediate-term trend favorable to high-yield bonds, and we rotated back into the asset class.

That said, we remain ready to move quickly in the event that downside market volatility intensifies again. We are prepared to seek potential opportunity amid volatility—as with the rotation back into high yield earlier this month—but are equally prepared to step to the sidelines when our models indicate it’s time to do so.

Key risk factors

This year we have seen higher interest rates, the rise of oil and other commodity prices, and a stronger US dollar. However, we believe that the ability of risk assets to rally off October lows suggests that a market low may be in place and a year-end rally may see prices gradually move higher, despite volatility.

Market consensus for continued earnings growth, coupled with positive sentiment, could maintain a ‘bid’ for risk assets. Since forecasts are for a deceleration of GDP growth (and thus less pressure on interest rates and the dollar), the Federal Reserve may hesitate to hike rates four times next year as data confirms the slower growth. This could also reduce the currency pressure on emerging markets. Furthermore, recent dialogue with China on trade signals a reasonable chance that tariffs will not be raised in 2019 to 25% across the board. Markets may respond well to an environment of slower growth, less upward pressure on interest rates from FOMC policy, easing of trade tensions, and a weaker U.S. dollar.

In 2017, the stock market moved up or down 1% or more less than 10 times. This year, the stock market has moved up or down 1% or more about 50 times. (The average is around 60 times.) Moreover, half of the volatility may be caused by quantitative algorithms amplifying price action, since these programs are geared for lower volatility. If the magnification subsides, the VIX index of stock-market volatility may move lower and potentially confirm an upward trend for the next several months.

Despite some additional volatility, several indicators suggest that risk assets may move higher from here. Money flows suggest a ‘bid’ at generally lower valuations. Bond yields seem to have stabilized below 3.25% on the 10-year Treasury note.

From a 52-week perspective, the yield on the 10-year note has been in a range of 2.34-3.25. With the current move off its highs, the yield on the 10-year is about 3.18%, which is still over the 3.11% resistance level that was in place, but is not in a price spike higher toward 3.5%.

Rising yields have been correlated to a collapse in risk assets earlier this year and during October. Therefore, with yields stabilizing we think that risk assets may find support at current levels and move higher.

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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.