November 17, 2017 | by Matthew Pasts, CMT, CEO, BTS Asset Management, Inc.

On BTS’ Recent Shift to a Defensive Portfolio Allocation

Last week the high yield bond market weakened after a long period of relative stability. BTS rotated out of high yield as an asset class in our Bond Asset Allocation/Tactical Fixed Income and High Yield strategies. We think additional volatility is likely and downside risk is unattractively high.

Following are key points relating to risk to high yield bonds at present:

  • High yield bonds appear priced for perfection. With credit spreads, interest rates, inflation rates, default rates, and the unemployment rate all historically low, high yield bonds do not appear to have much room for capital appreciation. A bull case might be a continued environment of favorable economic activity, benign inflation, and low interest rates that allows investors to capture a 5-6% yield.

  • Investors are nervous. In the context of generally stable financial markets, the recent weakening in high yield prices suggests the asset class could see further losses. Even the initial drop in high yield bond prices seemed to cause large net redemptions in the leading high yield bond ETFs.

  • Spreads are tight. Credit spreads between low and high rated bonds are historically tight. The yield of high yield bonds compared to investment grade bonds offers a smaller yield pickup than has typically been the case in the past. This may continue to shift allocations out of high yield sector—adversely affecting prices.

  • Treasury yields may be poised to pressure high yield prices. Government bond prices have been under pressure during the last couple of months. The yield on the 10-year Treasury rose to 2.4%, which is a support level from May and July. A possible move to 2.6% and beyond could pressure the rest of the fixed income market. This may also increase allocation out of the high yield sector—adversely affecting prices.

BTS is monitoring support levels in the bond markets and signs of trend and momentum in the stock market. A selloff in either market could be followed by quick stabilization. Such a development might create an opportunity to re-enter high yield bonds at more favorable prices.

  • Inflation factors could contribute to making high yield attractive again. Although CPI readings suggest low inflation, stripping away deflationary sectors such as telecom (affected by price wars of major data carriers) reveals that inflation might actually be picking up. Increases in the CPI heading into the new year could push bond yields higher. The high yield sector is likely to reprice as Core CPI and PCE deflator begin to trend higher—this may happen during the next few quarters and create potential trading opportunities.

  • The stock market appears extended. The current bull market is long by historical standards and has progressed on low volatility. Valuations are historically high now. Although earnings growth has been solid, stocks could experience a correction as they revert to historically average ratios. The current level of prices compared to average earnings has historically led to low long-term returns. When stocks reach an extended condition, they are vulnerable to any disappointment, such as a lack of tax reform or other negative catalyst. If high yields re-price on any correction in stocks there may be a trading opportunity.

In summary, while BTS sees an increase in volatility as probable, we also anticipate potential trading opportunities to the extent that inflation increases and interest rates move higher than is widely expected at this time. We believe volatility in the stock market is also going to increase as the normalization of monetary policy creates added risk of recession. Though there may be a chance that the carry trade on interest and low volatility continue near term, we expect a more volatile 2018 for the high yield sector and markets in general.

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.

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