High Yield Still Has a Place in Most Portfolios
Even if you assume some widening of spreads and a lower total return, there is still a case to be made for including high yield in portfolios. Using the BlackRock Investment Institute’s five year capital market assumptions of 3.6%, which take into account how we think current economic and market conditions will play out in the medium term, traditional portfolio construction methods suggest a 5%-10% allocation in all but the most conservative portfolios. The reason why: Volatility is low compared to stocks, and yields are generous compared to other types of bonds.
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Market Realist – Volatility is approaching the low teens.
The junk bond (HYG) market gains when economic conditions improve. In contrast, recessions almost always correlate with down markets and rising volatility.
The three-month Volatility Index (or VIX), which measures the implied volatility of options on the S&P 500 stock market index, is approaching record lows. Implied volatility should rise or fall whenever there’s a potentially disruptive political event such as the US presidential election coming up in November 2016. That’s because financial markets are prone to dip or rally right after the event.
As VIX has reached record lows, the prices of speculative bonds have rallied, and vice versa. This can be seen from the SPDR Barclays High Yield Bond ETF (JNK) reaching its record low during February due to oil price volatility and China’s economic slowdown. Since March, the index has been moving upward due to the Fed’s dovish outlook on a rate hike and the uncertainty about a Brexit before the vote in June.
Analysts at the Bank of America Merrill Lynch suggested in a research note that implied volatility is extremely low because the market is overflowing with sellers of these contracts who are out to collect whatever premiums they can.
In the next part, we’ll take a look at the factors that junk bond investors should be cautious about.