As a result, investors are likely to be better off avoiding the most rate-sensitive investments in favor of those with greater credit risk (sensitivity to risk appetites and economic conditions.
In this sense, all of the areas I cited in December in my article “The Best Bond ETFs for 2013” — short-term high yield, international corporate debt, and target maturity corporate and high yield bond funds — can continue to be a source of incremental return in the months ahead. And if yields do in fact fall, these segments are likely to perform even better.
The outperformance of credit-sensitive segments can continue as long as the current environment remains in place, but investors need to be aware of two important risk factors.
First, any segments with elevated credit risk are vulnerable to adverse headlines. And there could be plenty of these on the way, with the continuing budget resolution and debt ceiling battle both on tap within the next four weeks. If these disruptions lead to a renewed selloff in risk assets, consider it a buying opportunity. While the prospects of a compromise appear bleak right now, they were equally so prior to the high-profile budget agreements in August 2011 and December 2012. If anything, disruptions caused by political noise would be a chance to add to these segments when yields are elevated.
The second issue — the outlook for global growth — is a longer-term consideration. For these segments to continue their recent strength, economic data needs to keep improving and/or exceeding expectations. (In the case of high yield and senior loans, domestic economic data is key; for the emerging markets, global growth is the critical factor). Any sign that the recent uptick has been a mirage would indeed change the equation for credit-sensitive assets and be an indication that it’s time to pare back on risk.
The Bottom Line
The “bond market” might still be unsteady, but that doesn’t mean investors can’t take on risk. In this case, it’s the type of risk that counts.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.