A Cautionary Take on High-Yield Bonds

On the last “Behind the Markets” podcast, Liqian Ren and I hosted two recurring guests. Bill Stone, CIO of Avalon Advisors, discussed joining Avalon and his global market outlook. Martin Fridson, CIO of Lehmann Livian Fridson Advisors, joined for the second half of the podcast to share his expertise on the high-yield bond market.

Stone’s Experience and Market Outlook

Avalon Advisors is based in Texas, and Stone has a more positive view on some of the major energy companies. Stone favors integrated oils, which have shown greater earnings, even as oil prices declined amid a broader sell-off in late 2018. The worst-performing sector over the past decade could be headed for a rebound. 

Stone is looking past disappointing recent retail sales data and believes that strong job and household spending reports will remain, while the confusion over the December retail sales data will fade.

Stone, Ren and I agreed that an impending trade deal between the U.S. and China has been about 90% priced into the market. Although there is still a risk there won’t be a deal, President Trump’s concern for the U.S. stock market and the Chinese government’s concern over its economy will likely lead to an agreement. 

In emerging markets, Avalon has increased exposure to Vietnam as a growing economy that would only be bolstered by the benefits of a trade deal.

Discussing factor strategies, Stone recognized problems in portfolio construction that are brought on by low-volatility tendencies to become heavily weighted in specific sectors and their rotation to other factors. Furthermore, Stone discussed how valuations on low-volatility stocks today tend to be in slower-growth and higher-multiple stocks.

Fridson on the High-Yield Bond Market

Following last year’s sell-off in the high-yield space, there has been a snapback in high-yield spreads so far in 2019. This has made it extremely difficult for high-yield investors such as Fridson to find value. 

Fridson heavily relies on a risk premium model and the yield spread over default risk free Treasuries for taking the risk of holding junk bonds. He bases this on the ICE BofAML US High Yield Index. Using this model, he sees current spreads as two standard deviations below his prediction, an extreme overvaluation. Fridson attributes this to the rebound in confidence this year and the decreasing supply of high-yield paper over the past several years.

Another interesting development in the non-investment-grade market is the positive-sloping yield curve. Traditionally, investors get higher premiums for shorter-dated instruments, but this situation has arisen from the lack of concern over default risk. Fridson highlighted the complacency that exists within the market for the lack of a negative yield curve. 

BBB-rated bonds increasing from a third to half of all investment grade-issued debt over the past decade is another development that could affect the high-yield space if there are more fallen angels during the next market downturn. Fridson believes the situation is not as dire as the media often portrays, particularly because many insurance companies that hold these bonds are not such forced sellers and take the time to remove non-investment-grade funds from portfolios.

Please listen to our full conversation with Stone and Fridson below.