When it seems everyone is piling into an asset class, veteran investors typically believe it signals the end of a bull market or the end of an economic growth cycle.
But Jim Brilliant, the manager of the highly rated CM Advisors Fixed Income Fund, believes the recent narrowing of the gap between high-yield bonds and Treasurys isn’t an ominous sign.
Instead, he believes the improving word economy signals continued strength for bond prices and a change in the stock market, with money shifting from higher-growth stocks into slower-growth value stocks in the energy, materials and industrials sectors as commodity prices strengthen.
This chart shows the gap, or spread, between the Bloomberg Barclays U.S. High Yield Index and 10-year U.S. Treasury notes:
As you can see, the spread has narrowed quite a bit, to only 3.06 percentage points, on Jan. 13. Within the past two years, the spread between riskier junk-bond yields and safer 10-year Treasury yields has been over 6 percentage points at times.
Spread compression and the warning
“We are in an environment where high-yield spreads have compressed to where they were in 2007,” Brilliant said during a phone interview.
That can be very alarming for those who recall all the market turmoil in 2008-2009 and the Great Recession following the credit crisis. But the chart shows the gap between government and junk bond yields was even narrower at one point in 2014.
The gap, or spread, then widened in 2015 and 2016 because of the crash in energy prices and the pressure that put on those companies earnings. “Every energy bond got creamed,” Brilliant said, which made investors fear that other bonds, aside from those with very high credit ratings, would be similarly crushed.
“In the meantime, there were opportunities in the materials and energy markets. I was buying bonds yielding eight or nine percent,” Brilliant said.
Many of those bonds have matured or have been sold by the fund, although Brilliant said he still holding many of them.
Despite that happy scenario for Brilliant, the narrow spread could indicate investors are complacent about bond prices, and many analysts are worried that bond prices are heading for a major tumble.
Last year, the Federal Reserve raised its target range for the federal funds rate three times to the current range of 1.25% to 1.50%. While that was happening, the yield on 10-year U.S. Treasury notes TMUBMUSD10Y, +0.87% actually declined from 2.45% at the beginning of 2017 to 2.40% at the end of the year, as investors didn’t fear inflation.
Brilliant expects the Fed to follow up with three quarter-point increases this year, which would bring the target range to 2.00% to 2.25%. But he also expects the Fed to be “mindful not to invert the yield curve,” a relatively rare situation when short-term yields are higher than those for longer maturities.
The yield on 10-year Treasury notes has risen since the end of the year and is now hovering around 2.55%. But considering that it declined in 2017 as short-term rates were rising, an inverted yield curve is a real possibility, which according to Brilliant is “generally a precursor to a recession.”
The silver lining and good news for value stock investors
But Brilliant believes things are different this time around, despite the traditional warning sign, because “now we have synchronized world economic growth,” based on the strengthening of purchasing manger indices.
And with the addition of major income-tax rate cuts in the U.S., Brilliant expects “a significant economic recovery is coming worldwide,” Brilliant said,.
The long period of historically low interest rates, combined with slow growth, was very good for high-growth companies’ stocks, Brilliant said. But now he sees the increased demand for oil and other commodities feeding greater interest in the long-neglected energy, materials and industrials sectors. This higher level of trust keeps bond prices high and yields low, while also setting the stage for strong performance of value stocks as the companies’ earnings improve.
With no sign that the U.S. may be headed into a recession for at least two years, Brilliant believes warnings springing from the narrow spread between high-yield bonds and Treasurys are overblown.
The fund
CM Advisors manages $1.4 billion, mainly in individual accounts, from its headquarters in Austin, Texas.
The CM Advisors Fixed income Fund CMFIX, +0.00% is a short-term bond fund with $68.3 million in total assets. Brilliant has previously called the fund’s relatively small size an advantage because some of the discounted bonds it buys are only available in relatively small quantities and greatly improve the fund’s overall performance.
The fund has a five-star ranking from Morningstar. Here’s how it has performed against its Morningstar category and Bloomberg Barclays U.S. Aggregate Bond Index, through Jan. 16:
| Total return - one year | Average annual return - 3 years | Average return - 5 years | Average return - 10 years | |
| CM Advisors Fixed Income Fund | 1.94% | 2.42% | 1.80% | 3.80% |
| Morningstar Short-Term Bond category | 1.48% | 1.34% | 1.11% | 2.22% |
| Bloomberg Barclays U.S. Aggregate Bond Index | 2.52% | 1.69% | 2.05% | 3.83% |
| Source: Morningstar | ||||
While the fund has greatly outperformed its category, it has underperformed the Bloomberg Barclays U.S. Aggregate Bond Index. However, it is less volatile than the index. The fund’s average effective years to maturity three years, while the average maturity for the index is 8.4 years, according to FactSet. The fund’s Sharpe ratio (its average return over the risk-free rate) for five years has been 1.04%, while that of the index has been 0.64%, according to Morningstar.
Despite the index’s longer maturity, Brilliant believes comparing it to the Bloomberg Barclays U.S. Aggregate Bond Index is fair, because the fund can be managed at longer maturities.
Cash and U.S. government obligations made up 47.6% of the fund as of Sept. 30. Among the top 10 holdings of the fund were bonds issued by Microsoft Corp. MSFT, -1.40% with a 1.55% coupon due on Aug. 8, 2021; AT&T Inc. T, -0.49% 2.02% due Feb. 14, 2023; Murphy Oil Corp. MUR, -1.56% 3.70% due Dec. 1, 2022 and Alcoa Inc AA, -0.92% 5.87% due Feb. 23, 2022.