Where does this leave investors?
To the extent investors are trying to maximize risk-adjusted returns, in our view, parts of the credit market look attractive, at least relative to U.S. stocks. Based on BlackRock’s long-term assumptions, some of the better return-to-risk ratios are in high yield bonds, EM dollar-denominated debt and bank loans. International stocks also look attractive relative to domestic ones thanks to lower valuations and generally higher dividend yields. Another potential asset class that scores well on expected yield relative to expected risk: preferred stocks. According to Bloomberg data, a broad basket of preferred stock currently yields around 5 percent with modest single digit volatility.
Based on our research, none of these asset classes are likely to produce the same type of double-digit returns that investors have enjoyed in recent years. But adding carry can help boost returns—or cushion a portfolio—at a time when returns will be harder to come by. This is probably not the right point in the cycle to try to replicate the halcyon days of the late 1990s.
Market Realist – Add carry to your portfolio to compensate for lower returns.
The graph above compares the yield on high-yield bonds (HYG) (JNK) with crude oil (USO) prices. It’s evident that the two move in opposite directions. Over the last three years, the correlation between the two has been -0.81. Remember, bond yields and prices move in opposite directions. So high-yield bonds perform well when oil prices are rising. This is because around 15% of the US high-yield issuers belong to the energy sector (IYE).
With oil prices rising, high-yield bonds have been outperforming. While oil prices aren’t likely to reach their highs anytime soon, they seem to have stabilized, which could support high-yield bonds. Preferred stocks (PFF) are also offering attractive yields. Read our series on preferred stocks for more.
Meanwhile, as we mentioned before, international stocks (ACWX), especially some emerging markets (EEM) such as India (EPI) (INDA), are appearing attractive. Brazil (EWZ) is trading at sumptuous valuations.
So what’s the bottom line? The ever-changing investing environment calls for a change in investment strategies. Adding carry to your portfolio in a low-return scenario could cushion your portfolio.