In early October, I commented about new market realities to embrace now. And now that quantitative easing is officially over, I’d like to highlight three portfolio changes that advisors are making in this new environment. The first change is below; look for the others in future blog postings on ThinkAdvisor.
The first trade in the series is a response to the eventual return of higher rates at the end of the yield curve. Allocations to high yield debt have been increasing ever since the junk bond correction a few months ago. The asset class has since recovered about one-half of its 4.5% drawdown, as measured by the iShares iBoxx High Yileld Corporate ETF (HYG).
The attraction of high yield is compelling. With the economy hitting on all cylinders, corporate bankruptcies will likely stay low. Muted interest rate sensitivity and a decent yield pickup relative to investment grade paper round out the reasons why many analysts are bullish.
But there are a few risks to consider. The average high-yield bond is trading significantly over par, which could cap the upside for the asset class. A bigger issue, however, is the rising percentage of junk being issued by oil companies. The energy sector now makes up over 15% of the high-yield universe. As a result, falling oil prices—which depress energy company earnings—will likely be a detriment to bond investors.
In my view, the rising dollar and weakness in Europe and China will only add to the price pressure on crude oil. Advisors may wish to hedge this risk by owning a managed futures fund (most are short the energy complex), or by capping their allocation to high yield debt.