The bottom line is that, as bond prices rise (reducing yields) and p/e ratios fall, the chances increase that stocks will outperform bonds. Thus the benefits high grade bond investors feel they're gaining through what they're buying can be undone by what they're paying. I'll say it another way: the attractiveness of one investment relative to another doesn't come from what it's called or how it's positioned in the capital structure, but largely from how it's priced relative to the other.
I'm impressed today by the ability to assemble a portfolio of iconic, high quality, large-cap U.S. growth stocks that will provide appreciation in a strong environment, a measure of protection in a weak environment, and a meaningful dividend yield regardless. To me, and given my standard view that we don't know what the macro future holds, these stocks' potential over a range of possible scenarios is more attractive than bonds which will do well in periods of economic weakness or deflation but poorly in strength or inflation.
Compared to stocks, I feel Treasurys and high grade bonds currently reflect all of the environmental factors in their favor and perhaps more and are priced rich relative to stocks. For them to do well from here, with yields so low, everything has to work out as the bond bulls hope.
My friend, hedge fund manager Doug Kass, publishes a daily note to investors. (Given that I average a memo every couple of months, I find the very idea daunting.) I usually like what he writes, which is another way of saying we think a lot alike. Doug's August 18 note carried a catchy headline, "Setting Up For the Trade of the Decade." His nominee for that sobriquet: shorting the U.S. bond market.
What about high yield bonds, one of Oaktree's flagship asset classes? They're selling at yield spreads over Treasurys that are well above the historic norms, and their promised yields to maturity (before credit losses) should help institutional investors toward their return goals. On the other hand, it must be said that if interest rates rise, high yield bonds will see interim markdowns (albeit cushioned by their modest durations and the "gravitational pull" of price toward par at maturity). In all, given today's yield spreads, we believe high yield bonds will outperform high grade bonds in most foreseeable long-term environments.
Leveraged loans may deserve consideration as well. The yields on these loans are low in the absolute, like other fixed income instruments, but relatively attractive at 51/2-6%. The loans are senior-most in the capital structure, meaning they should provide some protection in a sluggish economy, and the fact that their interest rates float with LIBOR should insulate them against interest rate increases.
Oaktree manages half a dozen large "multi-strategy fixed income" accounts, in which we are responsible for allocating capital to our various marketable securities strategies. Recently, in recognition of the developments described above, we made a modest initial shift away from high yield bonds and into convertibles, with their sensitivity to equity market trends. Here's what I wrote to our multi-strategy clients a month ago:
Certainly by the onset of 2000, people believed too much in stocks and thought too little of bonds. Now, a decade later, these things are reversing. As we enjoy our portfolios' performance, we should be alert for a day when bonds will have become too popular and stocks' outcast status will have rendered them too cheap. We can pat ourselves on the back for being in the right asset classes today, but we shouldn't fail to consider what these diverging performance trends can do to tomorrow's returns.
Since few investment trends continue forever, it's usually smarter to expect ultimate regression to the mean rather than growth to the sky. No one should view the great popularity of bonds relative to stocks without reservation.
September 10, 2010
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