Bonds

Over the past few months we’ve seen the largest high yield bond fund outflow since 2000. We will exercise patience for now and wait for a better entry point.

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Despite the exodus from all bond classes in the last few months, longer term demand for safe spreads is likely to remain strong and investment grade issuance has dropped significantly.

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The global economy is stuck in a “muddle through” mode with developed and emerging countries showing divergence in terms of leading indicators. Despite this divergence, they share one thing in common: an upturn in inflation. How much more room there is for easing is a key determinant of asset market performance.

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How do we avoid volatility in a high Uncertainty/low conviction world? We compare a “bi-modal” portfolio of 50% Treasuries/50% High Yields with a “middle-of-the-road” portfolio of 100% Investment Grade Corporate bonds. The latter wins in both good and bad scenarios.

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We remain optimistically cautious, as we believe the determination of the policy makers to prop up the market should not be underestimated, especially in an election year.

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Stocks win the bonds versus stocks comparison.

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Stock/bond Risk-reward relationship beginning to return to normal. Back in Q1 2009, performance differential between S&P 500 and 10 year T-bonds was at generational lows. In prior periods of bond superiority, stocks ultimately came soaring back. Expect to see stocks do much better over next 5 years.

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 Expect stock prices and interest rates to move higher together for a while. There are plenty of examples of this historically...although some of them go waaayyyy back.

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As of the end of Q1, the 20 year total return ACR differential between the S&P 500 and Ten Year Treasuries was negative, and at its lowest reading in 60 years.

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High Yield bonds are still rated Attractive, but the spreads have narrowed significantly.

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Despite strong stock market returns relative to 10-year Treasuries, the “generational anomalies” still exist. Stocks should outperform bonds going forward.

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During the past several years, it has become fashionable to believe that bond investors are more sophisticated than stock investors. Personally we don’t buy that bond investors have any edge in intelligence or diligence.

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So, over the long run, stocks are supposed to provide better returns than bonds as compensation for taking greater risk. Well the last 20, 30, and 40 year periods show that bond and stock returns have been at the smallest performance spreads ever. In some cases, bonds actually produced better returns. It’s pretty depressing huh?

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Credit spreads have blown out to levels not seen since the 1930’s. What are the implications for the market?

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High Yield bonds have reached our attractive zone at yields of nearly 14%. To us, a gradual accumulation program makes sense.

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Since economic fundamentals are providing little help lately, an understanding of bond sentiment has become especially helpful.

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We see little fundamental appeal in bonds at current yield levels, but would not be surprised if yields still drifted a bit lower in the next month or two—if only because so many players are positioned for the opposite.

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Bond yields continue to fall as economic reports have tended to be on the weak side. Massive global liquidity and the search for yield have also helped to push yields lower. We have been way off the mark with our predictions for higher rates.

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Our call for a bond market correction did not pan out in October, but yields did back up in early November as weak productivity and a surprisingly low unemployment rate were released.

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