Still humming, strong economy puts popular credit-risk investing strategies ... at risk

Key Points
  • In a very low-yield environment, taking on credit risk has been one of the best places to find income in the market over the last decade.
  • A major risk rattling stock and bond markets is geopolitical risk — in large part centered on President Trump.
  • As the Fed hikes rates, the short-duration bonds can keep rolling into higher rate ones, and long bond prices will rise if inflation and economic growth expectations retreat.

At just under 10 years, the current economic expansion is already old by historical standards, but it may get extended even further, thanks to tax cuts and government spending.

"We're in the eighth or ninth inning of this economic cycle, but the unprecedented late-cycle stimulus makes it an extra-inning game," said Elaine Stokes, a portfolio manager and strategist for several bond funds at asset manager Loomis Sayles.

An employee works at Pioneer Pipe in Marietta, Ohio.
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The long, weak recovery from the financial crisis of 2008–2009 has finally kicked into a higher gear this year. Stronger economic growth, rising inflation expectations and a policy shift at the Federal Reserve Board, however, will challenge one of the most successful investing strategies of the last decade: credit risk.

In a very low-yield environment, taking on credit risk has been one of the best ways to generate income in the market over the last decade. And other than a few rough patches, it has been a remarkably smooth ride.

The ride, however, is getting bumpy. Credit spreads have been volatile and fears of too much or too little inflation are causing wild swings in the market this year. That presents an opportunity in high-yield bonds, says Stokes.

"It's going to continue to be volatile, but we don't expect a big move one way or the other," she said. "The market is not as rich now, and I think it's too early to get out."

The yield on the Bank of America Merrill Lynch US High Yield Master II index has risen just under 40 basis points (0.4 percent), to 6.21 percent this year (through April 24), and the spread over the 10-year Treasury bond yield was up more than 50 basis points in early February. It has since narrowed to 3.41 percent as of April 24.

Stokes believes high-yield bond prices will continue to swing this year, but with low default rates, decent yields and the U.S. economy humming, investors will be happy just collecting their coupons. Because the length of the rally has compressed spreads in the market, she prefers higher-quality BB bonds versus lower-rated CCCs. "Investors are not getting paid to go down in credit quality," said Stokes.

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George Rusnak, co-head of fixed-income strategy for the Wells Fargo Investment Institute, thinks that's true of the whole high-yield market.

"We're surprised the high-yield market hasn't backed up more," said Rusnak. "We think it's too late in the game for high yield."

He is underweight the sector and overweight shorter-duration investment-grade bonds — particularly in the financial industry. The average yield on junk bonds is still near historical lows, and the spread over Treasurys is 150 basis points below the historical average.

"The coupon is not bad in this market, but it's not enough to make up for the risks," said Rusnak. "We could see negative total returns for high yield this year."

A major risk rattling stock and bond markets is geopolitical risk — in large part centered on President Donald Trump. Whether it's fears of a trade war with China, a confrontation with North Korea or what feels like chaos in his administration, Trump has ratcheted up fear in the markets. Geopolitical risk indexes are near all-time highs, and politics could quickly change the positive global economic picture. It could also send investors fleeing from risky assets, like stocks and high-yield bonds.

We're in the eighth or ninth inning of this economic cycle, but the unprecedented late-cycle stimulus makes it an extra-inning game.
Elaine Stokes
portfolio manager and strategist at asset manager Loomis Sayles

"The trend toward protectionism and populism could derail things," said Stokes at Loomis Sayles. "The geopolitical threat is very real and it can change sentiment on a dime."

Aaron Kohli, a financial strategist with BMO Capital Markets, sees signs that the end of the economic cycle is already close at hand. One of the clearest is pressure on corporate margins, which bodes ill for corporate earnings down the road.

"Inflation has been less responsive to wage gains than in the past," he said. "Producers don't have the ability to pass on costs through higher prices." The producer price index was up 3 percent in the 12 months through March, compared to 2.4 percent for the consumer price index.

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Kohli thinks inflation is unlikely to rise far above 2 percent, regardless of the fiscal stimulus that kicks in this year. He also expects that as the Fed raises short-term rates, the yield curve will flatten further and invert sometime later this year — a classic sign of an imminent recession.

"The 10-year Treasury yield has failed to hold above 3 percent five times now," said Kohli. "It depends on how fast the Fed raises rates and on global growth, but we expect the yield curve to invert in the third or fourth quarter."

If that comes to pass, credit risk — and high-yield debt, in particular — will be punished.

Kohli favors a barbell approach with low-risk Treasurys and high-quality long-term bonds. As the Fed hikes rates, the short-duration bonds can keep rolling into higher rate ones, while long-term bond prices will rise if inflation and economic growth expectations retreat.

"The long end could lose some ground at times, but I think it will outperform," Kohli said.

If there are extra innings to this economic cycle and to the performance of high-yield bonds, they're going to be nail-biters.

— By Andrew Osterland, special to CNBC.com