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.
By AARON KATSMAN
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 approach.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 category.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.AdvertisementI 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 funds?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 investment education.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 investments.Emotionally, I don’t believe they will stay the course.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 maturity.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 them...email@example.comAaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.
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