Peak Performance: Eye on Yield Spread

Has the maximum point of stress in the capital markets passed?

There's no one measure for answering the question. In fact, there's no convincing answer short of letting time pass. But for those looking for a bit of perspective in real time, among the worthy gauges to watch in search of clues is the spread in junk bond yields over the 10-year Treasury yield. By that standard, a minor milestone recently passed considering that this spread touched a recent peak of 7.93% last month (based on closing yields on March 17, 2008), as our chart below shows. The question: Will the peak will hold?

click to enlarge

Only time will tell, of course. Meantime, what lessons does recent history offer? For starters, an investor who bought junk bonds as an asset class at the peak, i.e., at the close on March 17 is now sitting on a 4.5% return, based on the price change of iShares iBoxx High Yield ETF (HYG) from that date through last night's close. So far, that's middling compared with other asset classes. The S&P 500, for instance, has jumped 7.5% over the same period--as per the Spider ETF (SPY)--while U.S. bonds generally have slipped by around 80 basis points over those weeks, as measured by iShares Lehman Aggregate Bond ETF.

Buying when risk premiums are high, or selling when they're low, is eminently reasonable and in the long run it may be the closest thing to a free lunch for strategic-minded investors. Accordingly, one might wonder if the 793-basis-point risk spread embedded in junk bonds last month was a buy signal for the long haul.

Perhaps. Looking at spreads going back to 1999, as we did last November, reminds that a near-800-basis-point risk premium looks pretty good based on the knowledge that the spread's high point over the past 9 years is only modestly higher, at roughly 1,000 basis points, reached for a time in 2002.

But let's not fool ourselves and think that spreads can't go higher, perhaps much higher. Even better bargains may be coming for those with investment horizons of five years or more. Alas, if we're honest, we must admit that we don't know for sure.

So, where does that leave us? In a familiar spot, actually, at least for readers of this blog: diversifying across asset classes and through time while favoring those assets that offer relatively attractive valuations and pulling back on those that look pricey.

The "catch" is that the best, and worst valuations will only be obvious in hindsight. That suggests two basic plans for dealing with the unknown.

* One, attempt to pick peaks and troughs and concentrate all buying, selling and rebalancing around those points in time.

* Alternatively, diversify the bet by recognizing that it's hard, very hard, to forecast valuation peaks and valleys ex ante. As such, we can invest a portion of our risk capital earmarked for new deployments over a period of time, concentrating those investments over spans of months or quarters that appear to be favorable to our long-term objectives.

The downside to the latter is that results will trail those of the investor who correctly allocates money at or near the peaks of valuation opportunities. On the other hand, diversifying across time will deliver superior results relative to the investor who tries and fails to identify tops and bottoms ex ante.

How to decide which approach is best? Much depends on one's skills and confidence as an analyst. No doubt there are some who excel in assessing risk and return opportunities. But for those of us who are less than brilliant in that regard, hedging our bets a bit is preferable, across asset classes and time. In fact, it's worth reminding that the population of less-than-brilliant investors is quite large, larger in fact than some investors realize. The real hazard, then, is that some of us don't yet realize our limitations.

Comments

[buyitcheap]

This seems like a very good indicator at the macro level, wonder if it could be applied by country/region, etc. i.e. euro, yen, etc. The yen though seems to be highly correlated with a lot of this market activity for the last few years.