Silver Linings: Allure and Risk

Sep.24.08 | About: iShares Core (AGG)

Financial crises, bank implosions and chaos generally don't often inspire. But every debacle has a silver lining. One of those linings shows up these days in higher interest rate spreads. Investors willing to wade into the riskier realms of debt are being paid for their troubles, or so one could argue.

As our chart below shows, you get more for your money these days when buying high-yield bonds and Baa-rated corporates, the lowest tier of investment grade debt.

High-yield bonds (as per Citigroup High Yield Index) offered an 875-basis-point yield premium over a 10-year Treasury Note as of Monday's close. Meanwhile, the yield on Baa bonds (represented by Moody's Seasoned Baa Corporate Bond Index) closed at 378 basis points over the 10-year the same day. As the graph above relates, those are the highest risk premia in roughly six years.

But are they high enough? Do they fully compensate for the turbulence ahead? Since we don't really know what degree or type of hazards await, we must remain agnostic when it comes to proclaiming definitive answers. Common sense, however, suggests that there's still trouble afoot, and so one can't be fully confident that the elevated risk premia noted above will suffice. But they might.

The potential for capital losses that exceed the received yield is an ever-present risk, and perhaps more so than usual in the early days of autumn in these United States. At the same time, it's getting harder to ignore the rising spreads. It may be too early to make hefty bets about the future, but it's not too early to begin dipping one's investment toes into the riskier ranks of bonds. That's especially true for those with an existing multi-asset class portfolio, a long-term perspective and an underweight position in lower-grade fixed-income allocations.

There are no guarantees with investing, but you can count on variations in risk premia. Ignoring the variations is imprudent, but so is diving in head first at the first uptick in yields. Finding a middle ground is the goal, and arguably that middle terrain begins with a toe in the water now.

Yes, spreads may be higher down the road. Or not. We don't know, and neither does any one else. You can bet the farm one way or the other. Alternatively, you could make modest buys on occasion, when the odds seem at least moderately favorable. Might these be one of those times?