This article was first released to Systematic Income subscribers and free trials on July 13.
Bill Gross, the former PIMCO “bond king” who now spends his time trading his own money, fighting with neighbors, and writing occasional market commentary, has published a fairly negative take on markets. His view is that as the Fed moves rates to a more “neutral” level, investors should sit it out. Specifically, they should get out of bonds, stocks, commodities and everything else. If they insist on holding anything, it should be 12-month Treasury bills which feature very little duration risk, no credit risk and a yield around 3%.
It’s true that relative to the post-GFC period, a level of 3% for what is a more-or-less cash asset is fairly appealing. However, it is also true that credit income assets are even more appealing as their yields have risen sharply this year.
One way in which we like to think about income allocation is through two concepts we find useful: opportunity cost and margin of safety. In income investing, opportunity cost gauges what the investor misses out when not taking risk.
If we use the 1Y Treasury yield suggested above as a reasonable low-risk income asset, then the opportunity cost is just the differential between higher-risk / higher-yielding assets and 1Y Treasuries. We like to use high-yield corporate bonds as a proxy for higher-risk income assets because the data is readily available. The chart below plots the differential in high-yield corporate bond yields and 1Y Treasury yields. In other words, the chart shows a proxy for the opportunity cost of being in 1Y Treasury yields.
For example, investors can now earn around 5.7% more by holding high-yield corporate bonds than 1Y Treasuries. This number is at the higher end of the last 6 years. If we go further back closer to the start of the post-GFC period the current figure looks less compelling, however, arguably it is not a good point for comparison because short-term rates were kept low in the post-GFC period as the economy recovered only very slowly.
What we also see is that the opportunity cost of being in higher-quality assets was relatively low at around 4% in 2021. This suggests that holding lower-quality assets in 2021 made a lot less sense than it does now because the compensation for moving to higher-yielding / lower-quality assets from “cash” was not particularly high. However, now that the compensation for holding lower-quality assets has risen, the opportunity cost for remaining in higher-quality assets is higher as well.
The obvious response to this way of looking at income markets is – well sure, the compensation for holding lower-quality assets is higher now but that’s because we are heading towards a recession, and we should expect lower-quality assets to experience significant losses.
Our view here is two-fold. First, we tend to allocate to the income market with a view that we could always end up in a recession in a year’s time. According to this perspective, the situation in 2021 was not materially different from the situation today. The only thing different is the compensation that investors receive for taking the risk that we could enter a recession in the near-to-medium term. That compensation was very low in 2021, and now it’s substantially higher as more of the recession risk is priced into markets.
And two, income assets don’t always do particularly terribly during recessions, even including such doozies as the GFC as shown in the table below. The performance of the high-yield corporate bond market is highlighted during recessionary and post-recessionary periods. The post-recessionary environments clearly offer superior returns, however, this transition can be too quick for investors to time.
Another important point is that investors are currently offered an attractive level of income which can partially or fully offset any further deterioration in the market. For example, in the shorter-duration high-yield corporate bond market investors can afford to see a further rise in yields of around 4% (they rose 5-6% so far this year already) before they start losing money at the current corporate default rate. This margin of safety is now much higher than it was in 2021.
Another way to think about margin of safety in high-yield bonds is that the downside is now lower in the worst-case scenario. Specifically, the average junk bond price is $87.50 and with the average recovery at $40 the average bond downside is around $47.50 or 54%. In 2021 the average price of a junk bond was around $105 so in case of default the loss would have been $65 or 62%. Obviously, 54% is still a lot but it’s not a reasonable amount to expect to lose in credit overall. This diminished downside can be easy to lose sight of when dealing in more abstract fund dollar price amounts.
None of this means that investors need to go all-in. We don’t know if a recession will actually take place (most analysts still peg this as a sub-50% likelihood). And if it does, we could very well see more pain across income markets.
However, there are things investors can do to mitigate this risk without having to remain on the sidelines.
One is to avoid a “back up the truck” allocation style and, instead, spread out the allocation over the likely range of income asset valuations. For example, a full-blown recession is likely to push credit spreads up to 10% from their current level of 5.2% (which are already around 2% higher off from their level at the start of the year). Putting some capital to work at current yields is clearly attractive and has worked well in the past as the following chart shows but having some capital remaining to put to work at even higher spreads and yields can minimize the potential for regret by choosing an arbitrary level.
Second would be to allocate to active managers that have been resilient through previous difficult market periods. One of these is the 8.9%-yielding Golub BDC (GBDC), which outperformed in the 2015 Energy crash period. Another is the 9.4%-yielding Ares Capital Corp. (ARCC) which strongly outperformed over the GFC period. ARCC is somewhat expensive at the moment, trading at a valuation 8% above the sector average. However, it’s worth watching for a better entry point.
Third would be to maintain some allocation to shorter-maturity assets such as the 7.8%-yielding mortgage real estate investment trust (“REIT”) Arlington Asset Investment Corp 6.750% Notes due 2025 (AIC). The company has a primarily agency allocation with relatively low leverage and high debt coverage.
Finally, it would be good to maintain some exposure to unleveraged assets such as exchange-traded funds (“ETFs”) or individual preferred shares. Even something like the SPDR Bloomberg Short Term High Yield Bond ETF (SJNK) mentioned above can fit the bull.
Our key takeaway here is that allocating within the income space with an eye to opportunity cost and margin of safety can allow investors to operate with a broader perspective in mind as well as enable them to achieve their goals.