Your Investments: Investing in high-yield bonds
Not only are they losing today relative to inflation, a shock is coming in the near future in the form of higher interest rates and loss of investment capital.
Isreli currency. Photo: Reuters
Ever since Michael Milken (a hero, but that’s for another column) and the
scandals of the late 1980s and ’90s, investors tend to get a bit nervous when
they hear about junk bonds (also referred to as high-yield bonds). They maybe
the most misunderstood asset class in the investing world.
I had the
opportunity to speak with Steve Blumenthal, founder and CEO of Capital
Management Group Inc., a quantitative investment firm based in Philadelphia, and
we discussed high-yield bonds.
What’s your approach to managing
high-yield [HY] bonds?
A quantitative-based tactical investment
In simple form, we trade the up trends, looking to capture both
price gain and high yield. We risk-manage and move to cash when high-yield bond
prices begin to decline. We wait patiently for a new uptrend to enter into a new
long-biased, high-yield trade.
What do you tell investors who are scared
to buy junk bonds? Why should they invest?
HY is a hybrid asset class sometimes
behaving like equities and sometimes like fixed income and sometimes both. The
relatively high yield tends cushion downside risk. One must be careful at points
of extreme, but if you study daily price history, you’ll actually see an asset
class with far less volatility than most any other investment
Importantly, risk can be managed. We have avoided significant
downside risk for over 20 years by systematically moving in and out of HY. Not
every trade is a winner, and of course there is no guarantee we will continue to
perform as well in the future.
Sticking to a disciplined process is
difficult for most individuals. Sometimes you will be correct with your trade
and sometimes not. If you try to outsmart your process for some human,
apparently intellectually based reason in the face of what your process is
telling you quantitatively, you’ll lose your edge. I have found HYs to be an
easy asset class to risk manage.
I also express to investors that risk
exists in everything.
You need to take risks. Placing money under your
pillow is risk – risk to inflation and risk to theft – bank investments are
risky, stocks, everything. Our perspective is that risk can be managed and that
preserving principal against loss is singularly important in order to enable the
process of investment compounding to work over time.
For retirees, why do
you believe that a managed bond portfolio is more effective than ETFs or mutual
If ones retirement date was magically aligned with a starting point of
high interest rates, like when I entered the business in 1984, [when] the
10-year Treasury was 14 percent, one can close his eyes and look to invest in
nothing else. Unfortunately for the retiring baby-boom generation, today, the
10-year Treasury is yielding under 2%.
More unfortunate is the lack of
Most individual investors do not believe they can
lose money in their bond investments. Not only are they earning less than
inflation, they have locked low returns in for years to come. Not only are they
losing today relative to inflation, a shock is coming in the near future in the
form of higher interest rates and loss of investment capital. It will be
difficult for investors to swallow a 20% loss in their bond
Emotionally, I don’t believe they will stay the
As in past bubble periods – tech and housing – I believe a shock
to their system is coming. Managed bonds and ETFs have no stated or defined
The maturities drift with the money flowing into and out of the
bond funds. My advice is to be patient, own short-term bonds and be positioned
for a better period in years ahead. Additionally, look to add tactical bond
strategies. High yield is a great asset class in this regard. There are other
tactical strategies out there that are available to all investors. Find
Aaron Katsman is a licensed
financial adviser in Israel and the United States who helps people with US