With near-zero interest rates and even negative rates appearing around the world, investors have rushed into high-yield ("junk") debt. This time on FS Insider, Tyler Kling of Macro-Ops explained why markets are likely facing a major inflection point depending on what happens in the junk bond market.
Junk Debt Will Signal Inflection
“What’s happened since the financial crisis is the Fed has lowered interest rates to zero and...you can no longer earn that much income just investing in government fixed income,” Kling told listeners.
As a result, investors are seeking riskier alternatives to government debt, such as high-yield ("junk") debt, real estate, dividend-paying assets and energy MLPs.
Junk debt now serves as key watchpoint for which direction the market is likely to head or if higher highs in the stock market are sustainable.
“If junk debt continues to stay bid up, and emerging markets continue to stay bid up, then investors are going to have a risk-on mindset, and any type of deleveraging scenario will be pushed off farther down the line,” he said.
Two Scenarios to Play Out
For bonds, this gets tricky, because while Kling sees the danger in long-dated debt that’s held into the medium term or long term, he thinks long-dated debt will actually rally in the short term.
“This may sound counter-intuitive, but in the shorter term, we actually like longer term debt, because we think the market’s going to go into a deleveraging scenario, and in that case long-term bonds will rally,” he said. “It’s not like interest rates can stay negative forever.”
After short-term action plays out, he sees one of two scenarios emerging: either deflation and deleveraging set in, or we’ll get an inflationary scenario.
Kling sees a higher probability of the deflationary scenario taking hold, and the noted that he’s been proven right so far by the price action in the 30-year this year. It’s actually had a pretty good year.
“If (deflation) happens, stocks will get hit and the 30-year will do just fine,” he said.
A big signal is that if central banks are throwing everything they have at the problem, and we still can’t get inflation, and we can’t get growth to go up, that means we’re experiencing a debt problem, Kling stated. The only way to fix that is to reduce debt.
“That’s why risk assets all sell-off,” he said. “In that scenario, you have that flight to safety.”
Sharpe Ratios and Implications for the 60/40 Portfolio
We can’t expect the traditional portfolio to perform too well going forward, Kling said.
“Over the last 5 years, that 60/40 (stock/bond) portfolio has had a 9.8 percent return per year,” Kling noted. “That’s with a standard deviation around 7.25 percent.”
Given these conditions, the Sharpe ratio – which measures return per each unit of risk — averaged 1.33 over those five years. That's extremely good, Kling noted, and he doesn't think that's sustainable.
The 70-year long-term ratio is .45, and right now we’re at 1.33, so to maintain the long-term average, we’ll need to see performance revert back to the downside, he added.
“As a 60/40, you’ve done very well in the last 40 years, and that’s great,” Kling said. “If you want to be prudent going forward, it might be wise to look at other options.”