Non-Correlated Assets in Unpopular Places
September 16, 2011
Finding Opportunities Where You Least Expect Them
One of the main themes we’ve discussed on The Wise Investor Show and implemented in our managed
assets has been the location of non-correlated, income-generating investments. In times of heightened
market volatility, especially secular equity bear markets, non-correlated assets tend to outperform popular
benchmarks like the S&P 500 Index and the Barclays Corporate Bond Index. Over the long run, noncorrelated assets can also add a layer of diversification to investment portfolios.
Today, as virtually every major media outlet reminds us daily, the most commonly-invested-in
uncorrelated asset is gold. However, other non-correlated investment opportunities do exist. They are
often overlooked because they often arise in unexpected areas. When recognized, these investments
are often negatively stereotyped because of their stigmatized asset class name. The mere mention of
high-yield bonds is often enough to discourage investors from considering them, let alone doing their due
diligence. We actually believe this “taboo” asset class is a good place to be invested right now.
After getting past the name, what you will find is a non-correlated asset class with current yield spreads
blown out to levels not seen since early 2008. The economics and investment implications remain
favorable as the Fed plans to keep “exceptionally low” interest rates in place until at least mid-2013,
virtually guaranteeing a zero percent return on money markets during that time.
High-Yield, Low Correlation
High yield refers to any fixed income investment issue rated below “investment-grade.” These debt
securities, also known as junk bonds, are issued by companies seeking to raise capital for various
purposes and rated by one of the leading credit rating agencies (i.e., Standard & Poor’s, Moody’s and
Fitch). The rating agencies evaluate bond issues and assign ratings based on their own proprietary
research analysis of the issuer’s abilities to pay interest and principal, as scheduled, with adequate cash
flows. In order for a high-yield issue to raise capital, they must entice investors with higher interest rates
to buy their bonds, compensating them for the additional risk of default they are taking.
Correlation measures the similarities or differences between two variables and how they react to one
another. Correlation values are between +1.0, which is perfect positive correlation, to -1.0, which is a
perfect negative correlation, allowing investors to see mathematically the relationship between asset
class, equities, fixed income, commodities, housing, etc.
High-yield bonds have low correlations (i.e., the extent to which the values of different types of
investments move in tandem with one another in response to changing economic and market conditions)
not only to the U.S. 10-year Treasury but to U.S. stocks as well. According to Bloomberg, from 1970 to
2010, high-yield bonds have been correlated -0.02 and 0.60 to the U.S. 10-year Treasury and U.S. Large
Cap stocks, respectively.
As always, past performance does not guarantee future results, but it can help us anticipate future
outcomes and spot opportunities. Today’s investors remain concerned that interest rates will spike higher
as a result of inflation in the not-so-distant future. Investors also tend to believe that investing in equities
during the current decade will be very similar to the S&P 500 Index producing a near zero percent return
in the last decade. Though valid, both concerns can be refuted with data.
High-yield bonds have a negative correlation to U.S. 10-year Treasury. Therefore, if interest rates do
rise, high-yield bond yields are not likely rise along with them, meaning the apparent interest rate risk is
reduced. When comparing high-yield bonds to equities, the last decade was not a “lost decade,” as highyield bond funds and indices produced positive returns. In some cases, the returns were over 6%
annualized despite having endured the Great Recession.
Spreads Remain Attractive
Today’s investors debate whether high-yield bonds should be bought if the economy looks like it may be
heading into a recession. Despite such doubts of high-yield bonds, we believe some clarity surrounding
the issue can be made by looking at spreads between high-yield bonds and U.S. 10-year Treasury.
Earlier this year, high-yield spreads were slightly above 500 basis points, and recently they’ve traded as
high as 750 basis points. The last time spreads were seen at these levels was in early 2008, not even at
the zenith of the Great Recession. At that time, high-yield bonds served as a foreshadowing barometer of
economic and market action, but they also provided an investment opportunity.
According to a scholarly study by Edward L. Altman from New York University, the spread between highyield and Treasury bonds is currently above the historical 1978–2010 average of 522 basis points. With
spreads currently higher than 700 basis points, history is telling us a fair amount of bad news, and
perhaps the chance of a mild recession has been priced in, which may potentially provide some
investment safety.
Friendly Fed and Low Default Rates
With the Fed’s effective zero interest rate policy and accommodations, many companies who issue bonds
considered high-yield continue to take advantage of lower borrowing costs. They often use these to
refinance debt as well as strengthen their balance sheet and existing cash flows. An example to which
most of us can relate comes from being a homeowner. Over the past years, many homeowners have
taken advantage of declining mortgage rates to improve their own personal finances. However, average
homeowners who refinanced are spending the money that was originally “saved.” They should be
following the lead of high-yield bond companies – strengthening their “balance sheet” (e.g., by building up
savings and improving cash flow), making it more durable and less sensitive during any future economic
storm.
With high-yield bond company balance sheets containing stronger cash positions and income statements
much leaner, companies continue to show strong earnings momentum, both of which have helped the
asset classes default rate to decline. Currently, default rates remain near historic lows of 1.5% due in
large part to companies extending maturities down the road in order to strengthen their financial position.
Conclusion
For all the points referenced above and ones we’ve made on The Wise Investor Show, we believe a
basket of high-yield bonds warrants investment consideration. Over the long-run, this unpopular and
under-owned asset class has demonstrated higher and non-correlated returns despite periods of volatility.
This sector stands to continue to benefit from an accommodative Fed remaining “on hold” and keeping
interest rates low until 2013. Therefore, with money market funds earning negative real returns, we
believe investors should search for yield in high-yield bonds as they reduce interest rate risk and offer
diversification with favorable economics. We also believe that spreads suggest gloom has been priced in
and an investment opportunity has been presented.
While high-yield bonds are certainly not for every portfolio, they at least warrant a conversation with your
financial advisor.
Diversification does not ensure against loss. Investments should not be made in any high-yield or high-dividend
investment solely on the basis of the income generating potential. The risks of investing in high-yield bonds include
the potential for default and increased volatility.
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Contributed by Randy Beeman & James Schneider. This is not a complete analysis of every material fact
regarding any company, industry or security. The opinions expressed here reflect our judgment at this
date and are not necessarily parallel with Robert W. Baird & Co. ISM Manufacturing Index- For
reference, the ISM is a diffusion index. A reading below 50 indicates contraction while a number above
50 indicates expansion.