Why I'm Lowering My Bond Exposure

During the time I have been making fundamental trade recommendations in EPIC Insights, I have always focused on absolute value. When stocks are cheap, I buy them. When they become expensive, I sell. This simple approach has kept us liquid and profitable by enabling us to book gains quickly and keep cash available to make new investments as opportunities arise. Over the months, repeating this process has worked extremely well as fundamental trades have accounted for 65% of the total portfolio gains.

While stock trades rely on absolute value, bond market trades rely upon relative value. Two factors affect the value of a bond. The first is interest rates. Rising rates push prices lower, and falling rates drive prices higher. The second is the risk spread needed to compensate an investor. Those who buy Treasury certificates require very little risk premium, while those purchasing bonds of speculative companies require enormous risk premiums.

Currently, we own three positions which track various sectors of the bond market. They are the Eaton Vance Senior Income Trust (EVF) as a proxy for bank loans, iShares Investment Grade Corporate Bonds (LQD) as a proxy for investment grade companies, and iShares High Yield Corporate Bonds (HYG) as a proxy for junk bonds. When we purchased these positions, risk was a four-letter word. Investors had rushed into government bonds and pushed the spreads on these risky instruments to levels not seen in many years. Recognizing the opportunity, we allocated 10% of our portfolio to these trades. When the spreads narrowed, we were rewarded. On a price basis, these three instruments have returned 24%. If you factor in the interest income earned during the holding period, the total return is even higher.

As I often state, reflecting on past gains is satisfying, but we earn our money on what happens tomorrow. As investors have become more comfortable with risk, spreads have tightened. At today's prices, we see credit spreads where they traded before the Lehman Brother's bankruptcy. Considering this, we must now attempt to gauge the direction prices will travel and what further upside remains.

Revisiting the two factors that drive price changes, interest rates and credit spreads, I am bearish on both. While the Federal Reserve has allowed massive liquidity to support the market, we must expect it to eventually trigger inflation and rising interest rates. With credit spreads tight, there is a greater likelihood that they will widen instead of contract further. Widening spreads and rising rates would act as a two-pronged attack on our portfolio and I see no reason to relinquish gains. While I still wish to maintain bond positions for current income and diversification needs, we do not need them to consume 10% of our portfolio. Instead, we will scale back and look for future opportunities. I recommend selling 50% of the positions in EVF, LQD, and HYG as this week's fundamental trade.

Comments

[Value Inter...:]

I agree, but for different reasons. The relative value trade in spreads normalizing from irrational levels earlier this year is over. LQD is back to pre-crisis levels, HYG is actually overvalued when considering likely High Yield default and recovery rates. Thus, investors are better off pulling back on duration in expectation of higher interest rates. However, higher rates will come not from inflation, but from the inevitable rise in treasury and mortgage rates as the federal government, and Federal reserve can't artificially hold these rates down forever.

Aug 09 12:08 PM

[GlobalTrekker:]

Sifting away all the clumps of verbiage, bonds are way up, so they're not cheap, so sell them.

Of course, that does little for the grand majority of us who make fixed-income investments in order to receive income, more or less fixed.

Guessing treasury and mortgage rates is a more foolish enterprise. I, too, can tell you with absolute certainty that they will go up. That means nothing. The question is when, precisely. That is immensely complex, and beyond the expertise of any of us writing here.

Aug 09 05:23 PM

[phillips49:]

You'll never go broke taking profit, but I'll hold a while longer myself. The ETF throws off 10% cash every month that I've used to invest in stocks. The dividend held steady during the financial crisis. The NAV has risen some 24% since the first of the year, which indicates that investors have some confidence in the underlying bonds. HYG currently sells at 1% premium to NAV which is not over priced. The equites market is over bought at this point and I don't see a good place to park the cash. I'm thinking that stocks are more of a risk at this time than HYG.

Aug 09 06:17 PM

[notagoldbug:]

high yield still trades at levels similar to low points of recessions...if no depression scenario HYG is still a good long term investment as default rates will be less than 14% goldman forecast eariler in year

i prefer active high yield managers as they will avoid defaults

Aug 10 05:15 PM