Waiting for Taper, Junk Beats Quality

Chidem Kurdas

What should one invest in while the Federal Reserve ponders what to do about its $85-billion-a-month stimulus? A chorus of managers answer: Junk bonds.

High-yield – as junk bonds are called in polite parlance – and convertibles, suggests Jack Flaherty, an investment director at GAM International. Also, he likes going long and short selected countries, especially among emerging markets.

In May, Chairman Ben Bernanke broached the topic of reducing and eventually ending the monthly infusion of money known as quantitative easing. In September, the Fed announced it was not ready to start tapering off, thereby proving wrong widespread expectations.

Market prospects that were uncertain before are even more so now. There is a queasy feeling of Waiting for Godot.

The pressure is off interest rates but could return with a vengeance whenever the Fed about-turn happens. That makes US Treasuries, long regarded as the main low-risk asset, a dangerous proposition. Treasuries have exceptionally low yield and are almost guaranteed to lose value when the taper comes.

Junk bonds by contrast pay you a substantial rate. But aren’t they too risky?

Historically high-yield has performed well in rising interest-rate environments, says Martin Smith from Penn Capital, manager of an American Beacon high-yield mutual fund.

He notes that prices of investment-grade bonds, such as those issued by Apple Computer this spring, declined. In other words, high-quality bonds have moved from the usual low-risk side of the spectrum towards the other end. In that respect they resemble Treasuries.

As for convertibles, Mr. Flaherty of GAM likes their combination of bond-like security with equity-like returns. Before the talk of taper started, opinion was divided on convertibles, one side seeing prices as too high. But this hybrid asset may be right under the current conditions.

London-headquartered GAM managed $43 billion in various types of mutual and hedge funds as of December.

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