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Bubble talk is on the march these days, and for an obvious reason: trailing return is high. But as I’ve discussed before (see here, for instance), I prefer to describe the ebb and flow of market prices as a reflection of fluctuating expected return. On the surface it’s a cosmetic distinction. But managing portfolio risk in a productive way requires looking at markets as offering a constantly changing menu of risk premiums. It’s more exciting to think in terms of bubbles, but such a focus can be distracting when it comes to our primary objective of earning a satisfactory return across a multi-year span. The reality is that we’re usually making decisions amid shades of gray vs. stark, clear extremes. Accordingly, our investment process should reflect this reality.

Why? Because the future’s uncertain and there’s no way to be sure that today’s overvalued monstrosity won’t stay overvalued for years. Similarly, it’s never really clear if assets trading at deep values will remain at bargain-basement prices for long periods of time. You shouldn’t ignore extremes in the markets. On the other hand, framing the dynamic state of pricing in a useful, practical way can help us stay focused on strategic goals.

The main reason I downplay the idea of bubbles and favor the notion of a dynamic state of expected return: thinking this way promotes and strengthens the case for managing risk by routinely looking for rebalancing opportunities. The devil’s in the details, of course, but in the end it’s all about sizing up risks and deciding where and when the potential payoffs looks negligible or attractive relative to the associated hazards.

That’s a difficult task, of course, since we’re forever in the dark about what’s waiting for us around the next bend in the investment road. But we can keep this threat under control and earn a decent return if we own a broad array of assets and make reasonable choices on when to adjust the weights of a portfolio’s components. Yes, we’re working with imperfect information, but there’s no way around that challenge and there never will be. The next best thing: look for ways to make deficient information a bit less deficient.

As an example, consider the state of the high-yield bond market at the moment. The yield premium for this asset class over Treasuries is quite thin, based on the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread Index. At 3.78%, the spread is near the lowest level in seven years. In fact, the last time we saw such a meager spread was on the eve of the Great Recession. I don’t think we’re on the cusp of a new recession (see this post for my reasoning), but junk bonds still look priced to deliver weak performance.

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As I explain in Nowcasting The Business Cycle, there’s a deep pool of research that tells us that we assume a fair amount of risk when we ignore extremes in yield spreads. As usual, however, there’s always a debate in real time about whether this time is different. Morningstar’s Sam Lee summarizes some of the possibilities for thinking that the historically small spread may not be as troubling as it appears:

So why are investors willing to pay such high prices for junk bonds today? There are two plausible and non-mutually exclusive explanations. First, the market might be forecasting much lower annual credit losses. PIMCO, BlackRock, and many other managers believe the next year will be benign for credit, thanks to a recovering economy, ample liquidity, and low interest rates. Second, investors’ desperate search for income has pushed high-yield bond valuations near bubble territory.

There may or may not be a persuasive economic case for the low yield spread, but from an investment perspective it really doesn’t matter. If your allocation to junk bonds is substantially above the target weight, prudent risk management implies that it’s time to lower the portfolio’s exposure to this asset class. The key reason: expected return for high-yield bonds has fallen.

For all we know, junk bonds may be poised for a strong rally, perhaps one that runs for a year or two. But prudently managing risk through time suggests that we won’t fall into the trap of thinking that we can beat the odds this time, or next time. Instead, we should be looking for reasonably attractive expected returns that appear to compensate us for the given level of risk–and then weight the assets accordingly.

Yes, this plan will sometimes forgo profits, but it will also keep us out of trouble most of the time. The latter point is far more important if we’re holding a broad array of asset classes and remain wary of letting pieces of the portfolio go off the deep end.

So, are junk bonds in a bubble? The question is irrelevant. Instead, ask yourself: Will the expected return likely compensate you for the risk over the next three to five years?

In fact, you should be asking this question regularly, for every asset in your portfolio. How should we estimate expected return? That’s a subject for another day, although you might start with a basic review of what’s known as projections of equilibrium risk premiums–a methodology, by the way, that currently projects relatively low returns for high-yield bonds. As for the popular habit of looking for bubbles, that’s a job better left to TV pundits and headline writers.

Source: Low Yields And High Risk