Will This Yield Train Run Out of Tracks?

With three trading days left in 2012, investors shouldn't expect much volatility between now and Jan. 1... unless we get a major surprise on the fiscal cliff (see the first item below). Stocks have opened up small, with the Dow (DJINDICES: ^DJI  ) and the broader S&P 500 (SNPINDEX: ^GSPC  ) gaining 0.2% and 0.1%, respectively, as of 9:58 a.m. EST.

Fiscal cliff watch
President Obama has cut short his traditional Hawaiian Christmas in order to return to Washington to continue negotiations to avert the "fiscal cliff," the $600 billion in tax increases and automatic spending cuts that are scheduled to take effect next year.

The odds that both sides will produce an agreement before Jan. 1 are now low -- less than one in five, if I had to venture a guess – and I think Mr. Market accepts this. That isn't necessarily a curse: The country would be better off with a January/ February agreement that actually addresses long-term budgetary sustainability rather than a last minute shambles cobbled together with Scotch tape and toothpicks ("kick-the-can" is the official term for that policy option.)

If you want to juggle scenarios, Reuters counts seven ways the "fiscal cliff" could end.

The macro view
The Financial Times' James Mackintosh tweeted this last Saturday:

Marty Fridson finds only 3 times in last 33 years have junk bonds returned yield plus or minus 2%. Yet most forecasts for 2013 are +/- 2%...
-- James Mackintosh (@jmackin2) Dec. 21, 2012

In fact, using a series from Ibbotson Associates going back to 1926, that frequency holds up: Junk bonds have produced an annual return in the range of +/- 2% in just 8 of the past 87 years (roughly 9%). After a drubbing in 2008, junk bonds have had a remarkable run over the past four years, with gains well in excess of nominal yields:

Year

BofA Merrill Lynch US High Yield Master II Total Return Index, Annual return

2012

+15.5%*

2011

+4.4%

2010

+15.2%

2009

+57.5%

Source: Federal Reserve Economic Data. *As of Dec. 21.

At 7.8%, junk bonds' 10-year after-inflation annualized return is better than four percentage points above the long-term historical average. As global high yield issuance rose 38% this year to a record $397 billion, those "high yields" have shrunk to historic lows. This is a cyclical market – those observations ought to give investors some pause. While there are no obvious catalysts for a reversal in this market, investors expecting to reap similar performance over the next three to five years from products such as the SPDR Barclays High Yield Bond ETF (NYSEMKT: JNK  ) or the iShares iBoxx Corporate Bond ETF (NYSEMKT: HYG  ) are likely to be disappointed.

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