SPREADING SKYWARD

The biggest challenge in strategic-minded investing lies within. The high-yield bond market of late offers a telling example.

Trailing yields on junk bonds have soared recently, as our chart below shows. The risk premium on junk over 10-year Treasury Notes exploded skyward to close yesterday at nearly 15%. That's the highest since the early 1990s and, one could argue, it looks enticing.

The human mind, meanwhile, is a complicated organ. What looks like far better values today relative to, say, June 12, 2007 isn't necessarily obvious or compelling to homo economicus. We cite June 12 of last year because that was the trough for the junk/Treasury yield spread, as per Citigroup High Yield Index.

Not long after, we remained suspicious that the spread was sufficiently high to compensate for the risks ahead, as per our post in late summer 2007. As it turned out, we weren't wary enough, not by a long shot. We did, however, say that even though the risk premium had risen to a bit over 4% in August 2007, "we're not yet convinced that strategic opportunities are convincing in the highest-risk spectrum of assets." In fact, we should have told everyone to run for the hills and put everything in cash. Hindsight, as always, tells us exactly what we should have done.

As it turned out, the crowd had other ideas, which is to say bullish ideas. Indeed, the late summer of 2007 was a strong period for the junk bond market. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), for instance, had a run higher in August and September of that year, reaching an all-time high of $104.70 on September 25, 2007. The ETF closed yesterday at $71.40.

Having been crushed, the high-yield bond market now offers its highest trailing yield in a generation. We're guessing, but it seems as though there are few takers, if any. Yes, there's reason to shun junk bonds, starting with the high odds that a painful and lengthy recession awaits. If so, defaults on junk will rise. Understandably, that scares off the bulls. And for all we know, staying scared may be the only logical decision at this point. An economy that takes a beating will treat the lower-grade tier of securities harshly, even after the harsh treatment to date.

In fact, there are always convincing reasons to shun those asset classes when they've fallen on hard times. The process works in reverse too, as so there's always a bullish rationale for buying more even though the valuations look thin and the assets are priced for perfection.

High-yields bonds are but one example of this ebb and flow of greed and fear. Granted, junk offers one of the more extreme cases of boom turned bust. Yet all the asset classes suffer this back and forth, albeit in varying degrees.

No, we don't know if high-yield bonds are about to soar in price, run flat for many years, or dive deeper into the hole. All we know is what's passed and the prices currently offered by Mr. Market. By that standard, the prices look a lot better now than they did on June 12, 2007 for junk. What does that imply for the future? We can't say for sure, but we have our suspicions.

Keep in mind that we've made a number of comments this year that the junk spread looked relatively compelling, i.e., it had risen. We now know that we were early in making such comments. We may still be early, and in fact that seems probable. Rest assured we have limited, if any skill in short-term market timing, and it's debatable if we're any better on a long-term basis. As such, we favor diversifying by asset class and trying to exploit seemingly compelling valuations over time.

Junk bonds should never represent more than a tiny slice of a strategically diversified portfolio, in part because the market capitalization of such bonds relative to everything else is tiny. But there's a case for upping the allocation to this corner of fixed-income a touch these days, given the sharp rise in yield premium. Then again, there'll probably be an even stronger case for upping the allocation a month or a year from now. So it goes when mere mortals such as your editor attempt to divine the future by analyzing the present.

At some point the junk spread will top out, just as it bottomed out back in June 2007. We'll always miss the absolute tops and bottoms. But if you have a long-term view, you can't afford to miss a major turn in a cycle, and in fact you don't have to, at least not completely. But there's a catch: being wrong at times. Sometimes you have to be willing to lose a few battles to win the war.