High Yield Bond Investors Look Down from the Tightrope: Q3 2020 Portfolio Managers’ Quarterly

In our flagship Tactical Fixed-Income strategy, BTS is currently invested defensively in money markets.

Our exit from high yield bonds in the latter part of September was not due to the emergence of new market or economic risks—or even the intensification of existing ones.

What changed, rather, was investors’ comfort with those risks. Right now, investors are like the tightrope walker who looks down while far out on the wire.

In this letter, we’ll touch on what investors are seeing as they “look down”—and what we think many people may be missing. First, though, we’ll briefly sketch out our positioning over the course of the quarter.

BTS Positioning

For most of the third quarter, we were invested in the high-yield market in a “risk-on” positioning consistent with a medium-term positive price trend. During parts of July and August, we also employed a partial hedge consisting of Treasury bonds.

As we have said several times this year, it’s important to seek to participate in what may be bear-market rallies—because you never know which rally will turn into the next bull market.

We were happy to participate in part of the apparent upward trend in risk asset prices until early September, so long as investors were relatively sanguine. Initially, even early September’s downturn did not lead us out of the market. After all, we have seen investors respond dramatically to positive news about fiscal and monetary stimulus. The same could have occurred, which is why we seek trend confirmation.

But no snap-back came. After a couple of weeks, our momentum indicators had deteriorated sharply, prompting us to exit the high yield market.

Technically speaking, high-yield bond prices broke downward through a “double bottom,” which could reasonably be taken as an indicator of coming trouble for the stock market as well, given the greater wariness among bond market investors this year.

Another sign of trouble for stocks has been the VIX Index. Despite the S&P 500 Index advancing off its early September lows, the VIX has been “stuck” at a high level.

A third related signal is the recent new lows in the dollar index in combination with higher yields at the long end of the Treasury curve. These factors could limit upside potential in stocks.

The tightrope walker has his blindfold off, the wind is blowing, and it’s a long way down.