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Time to Increase Credit Risk Exposure

by: David Merkel posted on: January 31, 2008 | about stocks: BLV / BSV / CIU / HYG / JNK / MSY / SHY / TLH

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Ugh, yesterday was a busy day. My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut. The bond market direction I got right.

Look at this post from Bespoke. Ignore the percentage increase, and just look at the raw spread levels. Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield. When you get to 10% yields, the odds tip in your favor on high yield. That said, today’s crop of high yield corporate debt is lower rated than in the past. Don’t go hog wild here, but begin to take a little more risk. I was pretty minimal in terms of credit risk exposure for the last three years, owning only a few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

For which of the following risks am I being adequately rewarded? Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
What are my client’s tax needs?
How much volatility is my client willing to tolerate?
How unconventional can I be without losing him as a client?
What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions. That is where I have been for the past three years, and now it is time to adjust that position. With respect to the list of risks:

Illiquidity: indeterminate, depends on the situation
Credit/Equity: begin adding, but keep some powder dry
Negative Convexity: attractive to add to prime RMBS positions at present.
Duration: Avoid. Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
Sovereign Risks: Avoid. You’re not getting paid for it here.
Complexity/Taint: Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
FX: Neutral. Maintain core positions in the Swiss Franc and the Yen for now. Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now. The biggest changes are on credit risk and FX. That’s a big shift for me. If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views. Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often. I’m not trying to catch small moves. Instead, I want to average into troughs before they hit bottom. If you wait for the bottom, there will not be enough liquidity to implement the change in view.

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