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Portfolio > Economy & Markets > Stocks

Rethinking High Yield

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March was a particularly onerous month for investors, but even more cruel for those who believe in the power of diversification.

Virtually all asset classes were down last month. As March progressed, it seemed like every sector of the market that exhibited strength earlier in the year — including large cap growth, and sectors such as utilities, basic materials, and energies, slipped into the red. Alternative investments such as hedge funds and managed futures didn’t offer much of an oasis either.

There are several reasons why all asset classes became highly correlated as their prices headed lower. Credit spreads widened significantly after GM announced a huge first quarter earnings miss, which shock investor confidence to the core. If the $300 billion in GM bonds are downgraded to junk status–a scenario that is quite plausible–it would rock the high yield market to the core.

The problem migrated to the higher end of the credit curve as well. AAA spreads against Treasuries also widened, which translated into losses for holders of Lehman aggregate-pegged mutual funds. There simply was not any place to hide in March.

We last discussed high yield bonds in February. At that time, we noted that default rates were heading lower, and that with their wide spread to Treasuries it was a great time to overweight junk bond positions.

The same logic no longer applies. As the spread between junk and Treasuries have narrowed over the last few years, and supply issues like GM beckon, we feel much less enamored with the asset class.

As a result, we are advising clients to reduce their credit exposure. There’s a chance things could get really rough, so it’s wise to stick with higher quality, lower duration fixed income positions, because a flight to quality could buoy Treasuries.

Historically, stocks and bonds do not correlate highly. The reason is simple – they are very different asset classes. Once markets revert to normal, it should be easier to see what move to make next.

Index Mar-05 QTD YTD Description
S&P 500 Index* -1.91% -2.29% -2.29% Large-cap stocks
size=”-1″>DJIA* -2.44% -2.59% -2.59% Large-cap stocks
Nasdaq Comp.* -2.56% -8.10% -8.10% Large-cap tech stocks
Russell 1000 Growth -1.82% -4.09% -4.09% Large-cap growth stocks
Russell 1000 Value -1.37% 0.09% 0.09% Large-cap value stocks
Russell 2000 Growth -3.75% -6.83% -6.83% Small-cap growth stocks
Russell 2000 Value -2.06% -3.98% -3.98% Small-cap value stocks
size=”-1″>EAFE -2.47% -0.10% -0.10% Europe, Australasia & Far East Index
Lehman Aggregate -0.51% -0.48% -0.48% U.S. Government Bonds
Lehman High Yield -2.91% -1.61% -1.61% High Yield Corporate Bonds
Calyon Financial Barclay Index** -0.39% -2.01% -2.01% Managed Futures
size=”-1″>3-month Treasury Bill 0.57%
All returns are estimates as of March 31, 2005. *Return numbers do not include dividends. ** Returns are estimates as of March 30, 2005


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