You are most likely familiar with the old adage “sell in May and go away” warning investors to sell their stock holdings in May in order to avoid a seasonal decline in equity markets. I do not necessarily advise investors to follow this approach. But as June is underway, I believe this time of year is a good time for investors to review their bond holdings.

There are certain types of bonds that I think work in the current environment and other types of bonds that don’t. That’s why I think it is important for fixed income investors to evaluate their bond holdings from time to time, to make sure your current bond allocations make sense relative to the interest rate environment and also make sense relative to the risk profile of the company or entity issuing the debt. This is what we do for our clients at Zacks Investment Management.

There are two types of bonds in particular that have somewhat of a shaky outlook, in my view, and may actually fit into the “sell in May and go away” mantra. They are long duration U.S. Treasuries and high yield corporate debt.

I’ll start with high yield corporate debt. In total, U.S. corporations have amassed some $8.8 trillion in total outstanding debt, which marks a 49% increase since the Great Recession ended in 2009. One of the main reasons debt has ballooned so much is that global interest rates have been kept low by central banks around the world, and yield-hungry investors have looked increasingly to the corporate bond market for fixed income.1

In some cases, this influx of new issuance has been positive. Small and mid-sized companies that previously had difficulty accessing debt markets could now raise money at better-than-reasonable rates, allowing for more risk-taking and innovation in the economy. For stock market investors, some corporations used the attractive debt markets to borrow money to buy back shares and increase dividends, both of which typically add shareholder value.2

But then there are the not-so-positive cases, where corporations use borrowed money as a band-aid to sustain a failing business model, or to give the appearance of increasing shareholder value in the short-term with no longer-term plan for investment and growth. That’s why since 2009, the level of global nonfinancial companies rated as speculative (junk bonds) has surged by 58%, to the highest ever, with 40% rated B1 or lower.3

On the opposite side of the risk spectrum from high yield corporate bonds, you find U.S. Treasuries, which I’m also not too bullish on in the current environment. In the month of May, both the 10-year and 30-year U.S. Treasuries crossed over the 3% mark, though yields plummeted in the final days on fears of Italy disrupting the eurozone (another story for another day).4 The uptick of the yield past 3% seems, in my view, inevitable given the Federal Reserve’s gradual path of interest rate increases coupled with a U.S. economy at full capacity and with the effects of the tax cut just working their way through. As the economy continues to grow with a tight labor market and no slack, inflation pressures should take hold, driving yields up even further in my view.

For investors holding long duration U.S. Treasuries, such an outcome isn’t exactly ideal – as bond yields rise, the prices of bonds fall, which can show up as a negative return in the near term for bond investors. Of course, bonds held to maturity would typically pay the interest rate as advertised, but there aren’t many fixed income investors out there who are actually holding bonds to maturity. These days, bond exposure is gotten through ETFs or mutual funds, many of which are managed according to a mandate that does not take into account changing market and economic conditions. All the more reason to re-evaluate your bond holdings today to ensure they align with your objectives. This is key to our approach at Zacks Investment Management where we design customized portfolios for our clients based on each individual’s unique needs.

Bottom Line for Investors

In the high yield bond world, the current default rate is just 3% for speculative-grade credit, but that has been in the backdrop of a healthy and growing U.S. economy.5 Should the tables turn or growth slow, there could be a massive unwinding and waves of default in my view. Investors should look carefully at the risk profile of your fixed income holdings, as strong investor demand for higher yields in recent years has allowed weak issuers to avoid default by refinancing maturing debt.

In my view, it’s not a great time to “set and forget” your bond strategy, just because there is a lot changing with the interest rate environment and the maturing of the economic cycle. Instead, focus on finding an investing strategy that meets your long-term investing needs. This is what we do for our clients at Zacks Investment Management.

Disclosure

1 CNBC, May 25, 2018 - https://www.cnbc.com/2018/05/25/moodys-warns-of-particularly-large-wave-of-junk-bond-defaults.html

2 CNBC, May 25, 2018 - https://www.cnbc.com/2018/05/25/moodys-warns-of-particularly-large-wave-of-junk-bond-defaults.html

3 CNBC, May 25, 2018 - https://www.cnbc.com/2018/05/25/moodys-warns-of-particularly-large-wave-of-junk-bond-defaults.html

4 U.S. Department of the Treasury, May 29, 2018, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

5 CNBC, May 25, 2018, https://www.cnbc.com/2018/05/25/moodys-warns-of-particularly-large-wave-of-junk-bond-defaults.html

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