Record Junk Bond Sales Are A Good Reason To Conduct Portfolio Reviews With Clients And Prospects, As It Signals A Turning Point In The Economy
The best time to own high yield is during an economic expansion after a recession. Consumer confidence builds based on companies’ ability to raise cash for future investment. This fuels the economic recovery as people who were previously risk averse begin to take on risk.
This kind of change in momentum is good reason for a portfolio review.
Distressed US companies are using sales proceeds from issuing high yield bonds to restructure old debt or to stockpile cash for future investment. Fearing that interest rates will rise despite the Fed’s focus on keeping them low through 2014, issuers are grabbing the cheap money while they can.
The rally is an international one. European banks are being forced by regulators to diversify their risk. They’ve issued €25.1 billion so far this year, a 36% increase over first quarter 2011.
This could be an early sign the junk bond rally is topping out. Junk bonds have an inverse relationship to the market just like any other bond. When interest rates are up, bond prices are low. As buyers come into the market, they push up prices and yields come down.
Clients just now looking at these yields should weigh the possible effects on their portfolios.
If your client invested 15% of a $500,000 portfolio in high yield, that means she has a sub-portfolio of $75,000 in high yield debt. The cost of holding that yield as prices fall will need to be made up in another part of the portfolio.
That may be difficult to do. As confidence grows and interest rates rise, the up cycle can become extended. The principle of higher risk instruments can fall beyond the benefit of the high yield.
Here are some ways to manage high yield risk:
- Understand the cyclicality of the markets and the economy and pay attention. Monitor the cycle and adjust exposure accordingly.
- Designate a sub-portfolio in which to own high risk instruments. The percentage of assets that make up this portfolio should be gauged based on the client’s age, income needs, and real tolerance for risk (not what they think it is when the markets are good)
- Build a sub-portfolio which includes several issuers instead of just one. This will spread your client’s portfolio risk across companies issuing junk bond debt. Adding international exposure could be a component here.
Monitoring cyclical economic developments provides you with an opportunity for talking with clients and prospects about their portfolios. Use it to deepen relationships and attract individuals who are attuned with your mindset.
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