"Smart" Money reducing fixed income exposure - but how smart are they?

by Wayne Ferbert on August 22nd, 2012

In the last 2 days, two different high profile investors made significant changes in their fixed income exposure. First, PIMCO's head of corporate bond investing announced that he had already started decreasing his exposure to high yield corporates several weeks ago. In particular, the PIMCO fund he manages is paring the riskiest of their corporate bonds. Read about it here at Wall Street Journal.

The high yield category has had the best returns in the fixed income space so far in 2012. Some firms are making the opposite bet. In fact, I have contended for some time that if yields are to recover to more normal historical levels, the higher yielding funds should see the smallest decreases in value. To be more specific, whichever fixed income yields have decreased the LEAST in magnitude will see the smallest decrease in prices when yields start to go back up. But they will decrease in price if yields go up. That math is indisputable. 

While that math can't be disputed, there is no guarantee that all fixed income categories will move in unison. PIMCO argues that the high yield category is now at its lowest yield that anyone remembers at an average of 5.68%. They argue that their is no more room for these yields to go any lower. I would tend to agree with that. However, people said the same thing about Treasuries in early 2011 and that has been a losing bet now for 18 months.

The options market tends to agree that the yield has no more upside. If you try to sell calls on the popular high yield ETF with symbol JNK, you find no real premium in the at-the-money options. That means the options market doesn't think the price of high yield can go any further. Believe me, I have tried to sell calls on my JNK position more than once in the last year and it has proved challenging. 

What is my conclusion on the high yield market? Overall, I think PIMCO is early on the yield recovery trade. Pundits have been going on CNBC for more than 18 months with the interest rate recovery trade. But they have all been wrong. And I think they will be wrong for at least another 6 months. 

But eventually, they will be right. So, I think we need to put JNK on watch.  We are still long the position - with a married put as our hedge. However, as the September and December option protection comes up for expiration, I think it is time to consider setting the hedges at even high levels given the incumbent risk.

The other high profile investor to reduce fixed income exposure in a a specific category was Warren Buffet. One of his insurance companies reduced their CDS exposure to municipal bonds by a reported $8 billion+.  Not wanting to insure a municipality is the same as saying: I no longer think the premium I am paid for writing this CDS is worth it compared to the risk of default by the municipality that issued the debt. That is heady stuff.

I have a large personal position in Maryland munis. But I am not fazed by the Buffet move. I am not saying that I think Buffet is wrong to be worried about default by municipalities.  I am just saying that I live in Maryland and I see our economy up close and I trust the Maryland economy is not on the brink. The Maryland economy has long been a service based economy that gets a lot of strength from the government and defense industry around DC.

If the Buffet move worries you, ask yourself what you know about the states you have muni exposure in. More than likely, you own your own state for the tax benefit. If you feel comfortable that you have a handle in your own state's economic well being, then sleep well at night. But if you own munis from a state that you don't know real well that your advisor bought for you, ask him to justify the investment. If he can't, ask him to hedge it. If he can't hedge it, you are with the wrong advisor!


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