In recent years, many investors have become desensitized to credit risk. Low interest rates and yield-reaching investors, who were willing to lend to even the most speculative credits (corporations), helped to keep corporate defaults to a minimum. There is a school of thought which states that as long as rates remain low, corporate defaults should remain low. We do not share this theory. Bond Squad’s theory is: As long as rates don’t rise, corporate defaults should remain low. Although our theory is similar to popular wisdom, it is not the same.
A popular mantra among strategists and salespeople is that, even if interest rates rise, they will probably not rise much and that these low rates should hold down corporate defaults. We are not so sure. Asset values have largely priced in low rates for an extended period of time. Corporate default rates are largely the result of Fed policies, particularly among CCC and CC-rated credits. Even modestly higher interest rates could increase defaults among the lowest-rated corporate borrowers. As one moves up the credit ratings scale, the higher rates would probably have to go before corporate defaults start to increase loanable funds. As it will probably take the Fed a few years to finish tightening, aggressive investors should keep their riskiest fixed income investments (speculations) on the very short end of the curve and gradually move up in quality as they move out on the curve.
If one understands credit risk, one might be able to take a risk-on approach to fixed income investing. Bond Squad has a risk-on approach to investing at the present time. The degree of risk we advise for portfolios depends on the goals, objectives and risk tolerance of individual investors. We believe that monetary policy conditions should be beneficial for risk assets in general, but not necessarily beneficial for the riskiest fixed income assets. We are moving to a fully-invested stance and have set B+ as our lower bound for credit risk for our most aggressive portfolios. Our risk vs. duration for high yield credits is as follow:
CCC and lower: No holdings
B-rated: High-B only out to two years. BB-rated: out to five years.
Split-rated (BB/BBB) out to seven years.
In general, the riskier the asset, the shorter the duration. That is our strategy. It is our belief that, as policy renormalizes so should asset allocations. Low-rated corporations could find it more difficult and expensive to obtain financing.
Please bear in mind; this is a very basic discussion of duration and credit risk.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC