Market Musings 031222 part 1:
Income Bonanza Time

Today is an excellent time to hunt for income.

A Historically Bad Year for Bonds, so far

Did you know that bonds have had an extremely rough year?

Which is somewhat surprising – if you look historically at times when there has been economic uncertainty and the recession either about to happen or coming squarely into view, it is quite normal for economically sensitive asset classes like stocks and real estate to perform relatively poorly, as indeed they have done over 2022.

However, in general terms, when stocks and real estate do so badly because of a poor economic outlook, it is precisely at this point that bonds, and particularly government bonds, tend to go up.

They perform better because they firstly provide some security and more conservative investment. So it's a way for investors to de-risk their investments away from stocks and real estate.

At the same time, the weaker economic environment tends to be good for bonds, not only because of their safe haven qualities, but also because inflation tends to be lower as a result of lower demand.

Of course, 2022 has been an extreme outlier in this regard, because one of the key motors of this economic recession has been this unexpectedly rampant inflation, which is not usually the case when entering economic recession.

So 2022 has perversely been the worst single year for a balanced portfolio between stocks and bonds in the last 100 years for which we have data. In fact, according to Bank of America, 2022 has been the worst year in 230 years for US Treasury bonds.

Worst year in 100 years for US balanced 60 stocks: 40 bonds portfolio

Soure: Bank of America

Either way, this has been an extreme year for balanced investors in stocks and bonds because for once, both asset classes have done particularly poorly at the same time. Now, the last time that stocks and bonds both went down in the same year was in 1994. But even then, bonds hardly went down.

They went down a few percent, but not very much. In contrast, this time bonds are down sharply. US bonds, ten year bonds have lost 15% over the year to date, which is far and away their worst performance in many, many, many years. The same can be said for US corporate bonds investment grade corporate bonds in the US again, -15% year to date, making it the worst performance in 50 years by a long way.

Worst year in 50 years for global investment grade corporate bonds

Soure: Bank of America

So again we are setting records of the wrong sort here with bonds, but a much better 2023 can be expected. Why is that?

The poorer the starting point, the better for bonds going forwards

Well, because firstly, very obviously the starting point is so much lower when you have such a poor outlook for bonds. When bonds have performed very poorly, that means their prices have gone down a lot and their yields inversely have gone up a lot.

So for someone buying an existing bond today, you're entering at a much better price level because the prices have gone down due to inflation. However, let's say that inflation falls over the next year, two years, three years, which I think is highly likely. In fact, I think it's already happening.

In that case, one might expect the price of bonds to recover, the yield to go down, but more importantly, the price to recover. By buying today, as an investor, you are locking in a very healthy level of yield. In fact, you're offering the highest you're buying the highest yield. For instance, in US investment grade corporate bonds, today’s 5.8% average yield is the highest such yield in 14 years since 2008. Pretty attractive by anyone’s standards.

We also know that the long-term return to an investor of bonds, of any type of bond, is in general, directly related to the level of yield at which you enter. Put it another way, the higher the initial yield at which you buy the bonds, the better the long term return over the following five or ten years that you can expect as a result. Quite simply, and this is the highest correlation for bond returns, the initial yield. Initial yields are high today.

The Higher the Starting Bond Yield, The Higher the Long-Term Return

Soure: novelinvestor.com

Ergo, long-term returns should be good. Yes, as an investor, you'll have to be patient. Yes, as an investor, you have to expect some volatility, just as we've seen over the last year.

Inflation rates will fall, perhaps quickly

But at a time when inflation rates have visited the double digit area for the first time in decades, the money should be on inflation coming back down. It may not come back down to 2%, or even under 2%, to the area that we've seen inflation rest in after the great financial crisis in 2009, for sure. But it can still calm down significantly from here over the next one to two years.

US inflation expected to return to close to 3% in 1 year

Soure: St Louis Fed

And that, as an investor, should be pretty nailed on, because, after all, inflation what is it? It's a yearly change of measure of prices.

So if inflation comes down, it does not mean that things are getting cheaper. Do not confuse price change with price level. The price change on a year-on-year basis can even go down to zero. But the price level, all that a zero inflation rate means is that the price level stabilises. So it stabilises at a high level, that's all.

We are not going to see inflation, in my view, anywhere close to 2% in the next year to two years, and maybe longer. I believe we are in an era where inflation probably sits somewhere above 2% on average for quite a number of years, because of the change of environment, away from an abundance of liquidity of energy, of other raw materials, towards more shortages, as we've seen of late.

That being said, inflation rates can come down sharply, can maybe revisit at least the 3% handle. And from where we are today, that would be a very, very sharp drop in yearly inflation rate, which would be much better for bonds from this point onwards.

US, Emerging Market bonds are interesting

What areas within bonds can one look for to enter at juicy yield levels today? Well, if you're thinking about government bonds, which are traditionally the safer form of bonds, then in terms of absolute yield, the two areas to look at are for the traditional safe haven of US bonds, given that it's the biggest economy in the world.

Secondly, emerging market (EM) bonds are interesting, which clearly carries a much higher level of risk but also a high yield. As an example, the SEMB iShares JP Morgan EM Bond UCITS ETF offers a 5.9% dividend yield at present on a portfolio of US dollar-based government bonds from a wide range of emerging markets in Latin America, Asia and the Middle East.

Worries over global growth and the ongoing strength of the US dollar has put pressure on emerging market assets. What is interesting about the countries listed at the top of the geographical exposure of this iShares EM bond ETF is that:

1. they are principally economies with a young and growing population (good for economic growth), and
2. they also are in general heavy commodity exporters (energy, foodstuffs and metals) which should benefit from today’s higher commodity prices.

iShares JP Morgan $ EM Bond ETF

Soure: iShares.com

Starting with US Government bonds. I would argue today that if you're a US dollar investor based on US dollars the current yield of around 3.5% for 10-year US Treasury bonds is not so bad. Admittedly, it is not as good as it was a couple of months ago when it was over 4%. Nonetheless not that bad.

However, if you are a Euro or a sterling based investor, then in my view US treasury bonds are less attractive because then you are of course buying into the dollar at this current level which is still, although it has fallen, very strong today. So this may not be attractive.

Otherwise I would suggest looking at US corporate bonds. As I said. Now there are two basic types, without going into great detail. You have investment grade bonds which are based on companies of higher quality. These are companies with stronger balance sheets and stronger cash flows to underpin the payment of the regular coupon and then the repayment of the principal loan at the end of its term. In the US today right now on average you can get 5.8% from these bonds from lending your money to US companies in this way, for companies of this higher quality.

Then there is a second category which is the so-called high yield category. But remember this category of bond is also known as junk bonds for a good reason. In tough times they can be a real problem for an investor because yes, of course they offer a higher yield. But as we all know, this higher yield comes with higher risk. There is no free lunch here and you should be particularly careful at times of recession or prospective recession (as is the case today) because this higher risk can translate into default ie. companies not being able to pay the interest or even pay back the principal. Then you can may suffer what we call a default ie. The company is just saying sorry, can't pay you back and then you may lose some of your capital as a result.

Given that we are going into recession right now, I think it would be wise to avoid high yield bonds for the moment, even though they are very high yield, given the elevated risk of credit defaults.

So for now in the US and also in Europe, I would stick to investment grade quality corporate bonds only and that can be accessed via investment trust or via exchange traded funds. ETFs.

Funds holding loans can be a good option too

Moving on from there, we can also think about loans. Now there are all sorts of loans, but probably the best way to think about this in the US is through leveraged loans, which are unlisted loans which are usually floating-rate, not fixed rate (unlike classical bonds). These are used for instance by private equity funds and companies that take a high level of debt in order to juice up their returns to their investors on the equity part of the fund.

Now, the problem with these leveraged loans in a tough and economic environment is exactly the same for high yields, the risk of a loan default rises sharply. So again, for the same reasons, I would not be mad madly keen on investing here in leveraged loans.

In the UK, however, there is a category of loans which is interesting, which are those which are typically available via the investment trust route for accessing higher yielding loans via investment trusts because these are not things you can find in the market.

Remember also for corporate bonds, i.e. lending to companies in the UK, as a retail investor you have a selection of retail bonds that you can buy. However, many corporate bonds are only available in very large denominations, a minimum order size of £100,000 or even more.

So individual corporate bonds are not always accessible to everybody in small quantities; and for that reason funds are usually a much better way to go. So have a look at a selection of higher yielding investment trusts, whose function is to lend money to companies at high yield. These listed funds obviously do a lot of what we call due diligence in terms of background research to make sure that these companies are able, through their businesses, to pay the interest that they need to pay and also to repay the initial amount of length at the end of the term of borrowing.

UK Investment Trusts - Debt subsectors

Soure: theaic.co.uk
Note: as always, Do Your Own Research

But if you look at some of these investment trusts you can find yields going from 6% and higher at the moment, which is very attractive over the long term.

Investment Conclusion

So in conclusion I think there is an excellent decade high opportunity to invest in bonds and bondlike investments with high yields. I think the areas one should look at are principally in the corporate bond space in the US, Emerging Market sovereign bonds and also funds of high yielding loans, particularly via investment trusts in the UK.