Investors must take on a lot of risk today to generate incrementally higher return. This is evidenced by the top chart, which shows credit spreads for high yield corporate bonds closing in on record lows.
Now note the bottom chart.
When credit spreads are wide like they were in 2009, investors are paid handsomely to take risk. The market is priced for solid returns, with ample scope for positive surprises and little room on the downside.
When credit spreads are tight, however, theres little potential for strong returns, and heightened risk of loss should the credit cycle turn south. Note the tails on the probability distribution. Todays situation is similar.
Thats not to say the alternative 2.6% on the 10-year Treasury is more appealing. For this reason, we think owning a mix of both risky and safe bonds makes sense.
Importantly, we believe that todays scarcity of income is a temporary situation. We cannot be certain where Treasury rates are headed. But we are confident that the business cycle is alive and well. When the next credit downturn occurs, spreads will widen and opportunities will emerge to generate higher income from portfolios.
In the meantime, we discourage clients from pushing the envelope in the search for yield.