- Equity Valuations Remain High
- Prospects for High Yield Bonds Improve
- Tactically Managed High Yield Bonds Potentially Uncorrelated during Equity Declines
- High Yield as an Alternative to Investment Grade Bonds
Equity Valuations Remain High
We enter 2019 fresh after experiencing the first bear market in US stocks in a decade. Prior to that downturn, we witnessed investors across the spectrum willing to take on more risk in their portfolios, just in time for markets to fall, potentially exposing portfolios to losses in the fourth quarter. In this paper, we discuss the market environment and the outlook for tactically managed High Yield Bonds in 2019.
Valuations in equities markets remain high while recession risks have risen recently. The S&P 500 Index has a price/earnings ratio of 20.8, 32% above its mean level of 15.7. At 29.8, the CAPE ratio, which is a 10- year average of price/earnings on the S&P 500, is at levels only seen or exceeded in 1929 and 2000 1.
Meanwhile, according to a Reuters poll of economists, chances of a recession over the next two years have risen to 40%3. Although 2019 began with equity gains in January, advisors should resist increasing equity allocations beyond target allocations, as valuations and ongoing challenges to the economy may present challenges to gains, and the possibility of additional losses later in 2019 and 2020.
Prospects for High Yield Bonds Improve
As a result of the downturn in the fourth quarter, prospects for High Yield Bonds have improved over levels seen in early 2018. Perhaps most important, High Yield Bonds yields increased to 7.9%4 at the end of 2018. Returns are primarily made up of two components: yield and appreciation. By starting the year with this baseline yield, it already potentially positions the category for above inflation returns. Generally, when the spread between High Yield and Investment Grade bonds widens, return prospects for High Yield bonds improves.
Prior performance is no guarantee of future results. Investors cannot invest directly in an index.
In the fourth quarter, spreads widened from 3.5%, where they had been for much of the past year, to 5.3%.
Prior performance is no guarantee of future results. Investors cannot invest directly in an index.5
The High Yield Bond index below has historically shown gains during calendar years following years when the index produced losses. Looking back to 1988, gains in years following calendar year losses averaged 28%.6
Excluding 2009, a year when the index increased 57.5%, average returns in years following an index loss averaged 22%. While we’re not predicting a gain of 22% in 2019, the index may have a propensity to compensate and return to the mean in years following losses. In summary, if equities avoid a return to the declines seen in recent months, we believe the Toews High Income strategy may be poised for gains in the coming year.
Tactically Managed High Yield Bonds Potentially Uncorrelated during Equity Declines
But what if stocks fall and re-enter a bear market, as they did so abruptly last year. This scenario may provide an even stronger incentive to hold tactically managed High Yield Bonds. As we saw during the financial crisis, and have witnessed many times throughout history, different asset classes can be correlated, and move lower together, as the turbulence of market declines increases.
Toews High Income is designed to attempt to uncorrelate from equities and High Yield bonds when markets become turbulent and move lower. If markets again fall, being defensive may further improve prospects for gains (see above).
High Yield as an Alternative to Investment Grade Bonds
For the past decade, interest rates have been at historic lows. While the Federal Reserve has increased rates, investment grade (AAA) bonds currently yield just 3.3%.7 After inflation and fees, that means that investors may see little if any above inflation gains on their bond positions. At the same time, further interest rate increases could cause the principal value of investment grade bonds to decline. We recommend that Advisors use the Toews High Income strategy as both a diversifier, and a partial replacement for low yielding bonds. Due to the yields associated with High Yield bonds, as well as past appreciation during rebound markets, our strategy allows advisors the ability to potentially increase returns and produce above-inflation growth.
Our strategy also has had positive returns during some periods of rising interest rates.8 This allows us to potentially accomplish both of our core objectives of improving returns and addressing interest rate/inflation risk.
Advisors are currently confronted with two imperatives. First, if markets advance, it’s important to realize gains in investors’ portfolios to achieve relatively strong performance and maximize investor retention and satisfaction. Second, as we saw during recent market decline, significant losses often materialize without warning, and can move quickly. It’s equally important to remain vigilant to the many risks that confront our investors. Tactically managed High Yield Bond strategies position advisors to address both imperatives with a time-tested strategy.
Prior performance is no guarantee of future results. Investors cannot invest directly in an index. There can be no assurance, and individuals should not assume, that future performance of any of the portfolios referenced will be comparable to past performance. There can be no assurance that Toews will achieve its performance objectives. The returns were obtained in an unusual market which may not occur again.
Toews Corporation (Toews/TC) is an SEC registered investment adviser with its principal place of business in the State of New Jersey. This presentation is limited to the dissemination of general information pertaining to its investment advisory/management services.
This commentary may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.
This commentary is intended to provide general information only and should not be construed as an offer of specifically-tailored individualized advice. Please contact your investment adviser, accountant, and/or attorney for advice appropriate to your specific situation.
This document refers to the performance of the majority of Toews portfolios to illustrate the effect of Toews management on US and intl. stocks and high yield bonds. Performance of individual accounts varied based on the client’s investment risk profile and their specific investment funds. For your individual account performance, please refer to the enclosed quarterly statement or the quarterly statement recently sent to you. In addition, not all model portfolios were referenced in this letter. It is not, nor is it intended to be, a comprehensive accounting of Toews asset management. There are other portfolios that Toews manages that performed differently than what is referenced in this letter. For a complete list of GIPS firm composites, their performance results and their descriptions, as well as additional information regarding policies for calculating and reporting returns, please go to www.toewscorp.com. Toews Corporation acts as the investment advisor that implements the asset allocation and models for each of the portfolios.
(1) Source of Data: www.multpl.com; Date Accessed 1-31-2019
(2) Source of Data: http://www.multpl.com/shiller-pe/. Date Accessed 1-31-2019
(3) Source: https://www.fxstreet.com/news/us-recession-risks-on-the-rise-reuters-poll-201812140123
(4) As of December 31, 2018. Source: ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Effective Yield [BAMLH0A0HYM2EY], retrieved on 1/21/2019 from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY, January 28, 2019.
(5) As of December 31, 2018. Source: ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved on 1/21/2019 from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 28, 2019.
(6) Source of Data: The Index actually started in 1989, but has retroactive data which extended its history back to 08/31/1986.
(7) Source of Data: ICE Benchmark Administration Limited (IBA), ICE BofAML US Corporate AAA Effective Yield [BAMLC0A1CAAAEY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC0A1CAAAEY, February 6, 2019.
(8) The basis for selecting time periods was to look at when the 10-year U.S. Treasury yield was greater than 1% and rising for longer than 3 months, assuming there is a relationship between the 10-yr U.S. Treasury yield and interest rates.