Looking for a margin of safety

Brandon Snow's picture

Yesterday, I received a commentary on the high-yield market with a few eye opening stats from Grant Connor, a member of our income team:

  • Speculative grade bonds (CCC-rated) now trade at a yield of 7.8%, the lowest since 2007.
  • Bond substitutes are driving the stock market – for example: the U.S. REIT index and Utilities are up 15% and 10%, respectively. It looks like income money is taking on equity risk in the search for yield.
  • The last time high-yield bond yields were at 5%, as it is today, government bond yields were at 1.6%.

It looks like the Fed’s plan for asset reflation is working, and it’s driving the price of paper up across the fixed-income world and into bond-like equities. While capital appreciation feels good when it’s happening, it’s forcing investors to make a difficult choice: take on more risk for the same return or accept a lower return.

Putting this dilemma into context:

I find it fascinating that today you have to buy JUNK bonds in order to achieve the same absolute return you would get from risk-free bonds prior to the 2008 meltdown. As mentioned on a prior blog, you can’t look at returns without considering risk and its clear risk-taking continues to increase. Of course corporations and investment banks are taking advantage of the situation with both high-yield and investment grade bonds on pace for record issuance this year.

It’s also telling when you look within the markets to see how different types of stocks have been performing. While the more value/interest sensitive S&P 500 and Dow Jones indices have been hitting all-time highs, both the Russell 2000 (small cap index) and Nasdaq have had significant pullbacks over the last few months. In fact, the average stock in each of these indices is 20% below its 52-week highs. The leadership of bond-substitutes and the selloff of higher risk and economically sensitive names are not healthy in our view.

Most money managers live in a relative world where speculative bonds are still cheap “relative” to government bonds and stocks are cheap ‘“relative” to high-yield bonds.  We live in an absolute world where our clients’ (and our) capital is sacred and deserves to be paid appropriately for the risks taken on. We maintain our high cash positions across our portfolios and are comfortable with working hard to find value in these markets, and being patient with our cash positions until we do.

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