LQD, HYG: Waiting for a Buying Opportunity

by: Lawrence Weinman

I am not much of a market timer. I don't think I can pick tops and bottoms and under current circumstances I am pretty much comfortable holding my long term asset allocation along with the vxx and vxz "black swan" hedges. Actually, at this point I wouldn't even call them black swan hedges. A black swan is a large disruptive unforcastable event. I think the outlines of a severe crisis caused by more deterioration in Europe are clearly visible. It may be impossible to put a firm probability on it but if it occurs, I can't see how any observer could say it was unforseen. So the VXX and VXZ are hedges, but not black swan hedges.

One thing we do know is that markets overshoot in times of financial crises. It is certainly highly risky to try to pick bottoms in the equity markets. In the fixed income markets, the risk / reward for entering into positions in the midst of a crisis are far different. The yield spreads between investment grade corporates and treasury bonds and the high yield / treasury spreads inevitably move to extreme levels in the midst of financial crises.

For the long term investor, this represents an excellent opportunity to enter these markets. The spreads inevitably tighten, giving both a capital gain and the high yield. Should the investor enter the trade early, the downside is relatively inconsequential, the spreads will eventually tighten and he will only have the opportunity cost of not picking the exact best timing. Entering into long positions in intermediate term investment grade corporate bond ETFs like LQD or VCIT, as well as high yield bond etfs (JNK, HYG) at levels close to previous extremes in yield spreads offers an attractive risk/return. Of course, traders will enter into this as a spread trade (short the treasuries and long the credit bonds) even on a leveraged basis, I'll leave it to others to venture there.

In 2009 LQD returned 8.5%, HYG 28.6%. I don't think that we are quite at the point to enter these trades as seen by the charts that show recent history for the spreads. I dont think we are done with the Europe related crisis. But the time will come and I will be ready.

This chart is LQD over IEF (intermediate), the extreme at the high of the 2008 crisis was around 3%. The second chart is HYG over IEF, the extreme in 2008 was around 8%.

Current yields:
LQD =5.29%
HYG= 9.65%
IEF =3.81%

Click to enlarge

Disclosure: No positions