Over the last few months, I have noticed that “active” bond managers who run core fixed income strategies are reducing exposure to credit-sensitive sectors. Also, whether some funds are holding short-term bonds or more cash, they are positioning the portfolio for rising rates (at least within their mandate). Remember, bond prices go down as interest rates rise; short-term bond prices tend to outperform when interest rates rise.
These funds are getting more defensive in their positioning relative to previous time periods. Why would a bond manager be getting more defensive regarding credit and duration exposure? Maybe these managers believe that they will be able to sidestep a correction in the bond market by selling lower quality bonds and buying higher quality bonds, such as AA or AAA corporate bonds. When a bond portfolio positions for rising rates, they will lower their exposure to long-term bonds in favor of shorter-term bonds. Bond managers will do this to limit drawdowns and protect principal. Some bond managers don’t play the duration game because it is challenging to get right over time.
The chart below shows the ICE BofAML US High Yield spread over comparable US Treasurys for the last 20 years. The average spread is a little over 600 basis points. Today, the spread is 465. Now, we are only showing the last 20 years which affects the average, and there are flaws in the structure of the benchmark; but narrow spreads are a sign that credit has improved and could reverse course. The old cliche for buying stocks is to “buy low and sell high”; it seems that a good rule of thumb for investing in high yield bonds is “buy wide and sell narrow.”
Howard Mark’s highlights this in a memo he wrote in the summer of 2017.
At the late-2008 trough of the financial crisis, high yield bonds and leveraged loans yield almost 2,000 basis points [or 20%] more than comparable Treasurys, meaning anyone who bought and held couldn’t really lose. Then, as investors recovered their equilibrium and bought, prices rose and the yield spread contracted. Now the spread is merely average relative to history – a few hundred basis points. The net yields on these securities are still highly likely to be well in excess of those on Treasurys, but any capital appreciation would have to come from further spread contraction, and that certainly can’t be counted upon.
If you read Mark’s entire memo, he reiterates that he is staying invested but being more cautious and selective. The memo was written over the summer. He says he is always early in his warnings which is typical for most value-oriented investors as prices usually blow pass fair value. The mantra for value investors (whether they are buying stocks, convertibles, or bonds) is to invest when the current price is less than intrinsic value or when there is a considerable margin of safety. Mark’s track record certainly speaks for itself, and he has prided himself on being “prudent” with Oaktree’s portfolio when he sees other market participants not doing so. Being prudent does not mean going to cash but lightening up on the risk-taking. For instance, why would you be overweight high yield now relative to US Treasurys?
Mark’s is not the only one reducing exposures and becoming more defensive on a relative basis.
From Dodge and Cox Income Fund 2017 Annual Report (01/31/2018):
The most meaningful change to Fund positioning throughout 2017 was a further reduction to the credit weighting, a recurring theme since early 2016 when, from a credit weighting peak of 55%, we began the process of selectively trimming into a strengthening market. Individual issuer trims reduced the Fund’s credit weighting by six percentage points in 2017, following a similar decrease in 2016.
From Guggenheim Fixed Income Outlook 1st Quarter 2018:
Changes to our portfolio allocation during the fourth quarter are consistent with our strategy over the past year of gradually reducing credit exposure. In our Core Plus strategy, we reduced our corporate bond allocation – including investment grade, high yield, and preferreds – to the lowest level since the financial crisis, give low spreads across those sectors.
Oaktree, Dodge and Cox, and Guggenheim are considered “smart” money and understanding how these funds see the current environment is worth noting. Everyone on Wall Street is trying to “predict” when the next recession will happen in the US. The reason is that the best investors try to jump off the boat before it sinks, and though, we are not reading about the recession in the newspaper, many investment professionals are already positioning their portfolio’s for the inevitable.