The Aleph Blog » Blog Archive » Time to Begin Increasing Credit Risk Exposure

Time to Begin Increasing Credit Risk Exposure

Ugh, today was a busy day.  My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.  The bond market direction I got right.

Look at this post from Bespoke.  Ignore the percentage increase, and just look at the raw spread levels.  Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.  When you get to 10% yields, the odds tip in your favor on high yield.  That said, today’s crop of high yield corporate debt is lower rated than in the past.  Don’t go hog wild here, but begin to take a little more risk.  I was pretty minimal in terms of credit risk exposure for the last three years, owning only a  few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

  • For which of the following risks am I being adequately rewarded?  Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
  • What are my client’s tax needs?
  • How much volatility is my client willing to tolerate?
  • How unconventional can I be without losing him as a client?
  • What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.  That is where I have been for the past three years, and now it is time to adjust that position.  With respect to the list of risks:

  • Illiquidity: indeterminate, depends on the situation
  • Credit/Equity: begin adding, but keep some powder dry
  • Negative Convexity: attractive to add to prime RMBS positions at present.
  • Duration: Avoid.  Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
  • Sovereign Risks: Avoid.  You’re not getting paid for it here.
  • Complexity/Taint:  Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
  • FX: Neutral.  Maintain core positions in the Swiss Franc and the Yen for now.  Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.  The biggest changes are on credit risk and FX.  That’s a big shift for me.  If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.  Also, for those that have read me here and at, you will know that I don’t change my views often.  I’m not trying to catch small moves.  Instead, I want to average into troughs before they hit bottom.  If you wait for the bottom, there will not be enough liquidity to implement the change in view.

Bonds, Currencies, Macroeconomics, Portfolio Management, Real Estate and Mortgages, Structured Products and Derivatives | RSS 2.0 |

One Response to Time to Begin Increasing Credit Risk Exposure

  1. BriG says:

    “though I was wrong on the stock market direction on a 50 bp cut”

    Well it went up then down then up again so you can claim victory either way ;)


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

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Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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