Dalton, Mass. — I made a couple more trades in my portfolio last week, so I wanted to dedicate the bulk of today’s column to keeping you in the know.
A couple of my put/call hedged strategies reached a hair’s breadth of achieving their maximum return cap. The way these things work, as the prices go higher, the potential downside is reset. While the downside protection remains from the starting point of the ETFs’ anniversary date, you could “lose” the appreciation you had made up until that point.
That was wonky. Let me rephrase. I invested in some things that could go up but also could protect my money. They are often called “buffer funds.” Those buffer funds pretty much hit their upside limit, so I decided to cash out.
Let me tell you what I bought last week. There were three different types of portfolios in which I sold out of those hedged strategies. The “Moderate” portfolio was only a 6 percent allocation. I split the proceeds evenly into more familiar investments.
In my Moderate portfolio, I increased my allocation of the Nasdaq U.S. Dividends Achievers Select Index via the Vanguard Dividend Appreciation Index Fund ETF (symbol: VIG).
I also introduced a new high-yield (a.k.a. “junk”) bond position via the SPDR Bloomberg Barclays Short-Term High Yield Bond ETF (symbol: SJNK). That went into my Moderate portfolio, as well as my “Conservative” and “Conservative-to-Moderate” portfolios.
In my Conservative and Conservative-to-Moderate portfolios, the Innovator ETF funds I sold were about a 31 percent and 24 percent allocation, respectively. That was a lot. After I sold the Innovator ETFs, I added to VIG in both portfolios. And I also increased my exposure to the Dow Jones Industrial Average. I introduced a 7-8 percent SJNK allocation to those two portfolios. And I parked 8-18 percent in a high-yielding money market account. I’ll get that invested during the weeks or months to come.
As a reiteration, that money-market position is held in my more conservative portfolios. I intend to find a home for it, but I also prefer to take my time and meter out the risk.
One thing about bonds is that so many of them have unique characteristics. In particular, junk bonds are sometimes more correlated to the stock market than the bond market. For instance, during the pandemic stock market crash this year, junk bonds dropped by as much as 15 percent in price. That’s not the type of protection you’d typically expect from bonds. The prices of junk bonds are, in part, linked to the state of the economy. And the state of the economy, currently, is tied to the coronavirus. Given how close we are to distributing a COVID-19 vaccine, a strategy of risk avoidance is not as compelling as it was pre-vaccine.
Let’s talk about some pros and cons of SJNK so you can decide if it’s right for your portfolio.
The “S” in SJNK is a bit safer than its siblings “JNK.” The “S” refers to the shorter duration of the bonds held by the ETF. All else equal, the closer the bond is to its maturity date, the more likely the company will continue making interest payments until the company buys back the bond at par.
The yield of junk bonds is higher than most other types of bonds. Preferred stocks are a notable exception, but those investments take on characteristics of bonds and stocks. Hence, it’s not as fair a comparison. SJNK has an SEC yield of 4.82 percent. Although the yields of junk bonds are near record lows, the yield of SJNK is nearly double those of some municipal and investment grade bonds.
There is also bad news. The prices of junk bonds suffer when corporate bankruptcies increase. If defaults increase, you are less likely to get all your investment back. According to Moody’s Investors Service, the trailing,12-month U.S. speculative-grade default rate was 8.4 percent ending October. They expect this rate to increase to 12 percent by February 2021. Standard & Poor’s expects a 12.5 percent rate by June 2021. I don’t think that’s right; I think it will be less. I suspect the default rate to be lower in June 2021 than it is today. If I am right, then the prices could adjust upward to reflect that reality. If I am wrong, I can collect some interest payments.
I have to respect that Moody’s and S&P probably have hundreds of specialized analysts. My company, Berkshire Money Management, has five financial advisors and me. I decided to choose exposure to junk bonds (a.k.a. speculative-grade bonds) through SJNK. Not only does SJNK invest in bonds with shorter maturities, it also holds higher-rated, high-yield bonds. The bulk of the bonds are rated BB or better. That gives us a bit more protection.
If the behemoths Moody’s and S&P are right and I’m wrong, this trade won’t work out for me. However, I believe that the default rate has peaked. The economy will benefit from a COVID-19 vaccine, limited (as opposed to full) economic shutdowns and, eventually, another round of fiscal stimulus.
This article originally appeared in The Berkshire Edge on November 23, 2020.