When I was growing up, my grandmother had a large apple tree in her backyard. All the grandchildren and neighbor kids loved to climb this tree and enjoy the delicious apples. As each summer wore on, one had to climb higher and higher in the tree in order to find the best apples–low-hanging fruit always gets picked first. Climbing higher in the tree and reaching out onto thinner and thinner branches carried an increasing level of risk (and excitement). You never knew how far you could trust the branch until it was too late.
So it is with many bond investors today. They are reaching further and further out in maturity and venturing lower and lower in credit quality. They desire a better apple (higher yield). The problem is that they don’t always realize the full risk that they are taking. There are apples out there loaded with worms and disease. How should they protect themselves from the bad fruit?
For the last thirty years, U.S. fixed income investors have experienced a nearly continuous bull market in bond prices as interest rates have fallen from double-digits to low single-digits. At the same time, we have substantially increased our public sector debt. While the current low interest rate environment is great for borrowers, it penalizes the conservative saver in two ways: 1) low current yields and 2) above-average potential for future price decline. In other words, buying a bond today guarantees a historically low return on your investment.
Specifically, what are the primary risks when it comes to investing in bonds? For starters, swapping short-term bonds for long-term bonds will increase the duration risk in your portfolio. The higher the duration, the more sensitive your portfolio will be to changes in interest rates. Think of it this way—if your bonds have an average duration of 10 years, the value of your portfolio could fall 10% for every 1% increase in the general level of interest rates. That is some serious risk! It’s interesting that some of the people buying long-term bonds today are doing so because they think stocks are too risky.
The second real and present danger is credit risk. This is the risk that the issuer of your bond (a government or corporate entity) is not able to pay you back the promised interest and principal at maturity. Based on investors’ appetite for yield, companies are issuing new debt at a record pace. Year-to-date, more than $293 billion has been issued by companies rated below investment-grade (junk bonds). This easily surpasses the previous record of $271 billion in 2010. Historically, the lowest coupon rate issued by a BB corporate credit is 5.3%. Today, these types of lower-rated companies are issuing debt at 5.6%. Could the end be near?
Lawrence McDonald, head of LGM Group (a junk bond trading specialist), puts it this way, “The market is thirsting for yield and the Fed is pushing people to do things like this [take more risk in the bond market]. There’s no question that the punch bowl will be taken away at some point.”
An interesting point of reference with respect to credit risk is the price chart of the iShares iBoxx High Yield Corporate Bond Fund (HYG). This junk bond fund, hit an all-time high of $104 per share on 9/28/07. It then fell to an all-time low of $67.80 per share on 3/31/09, a price decline of 34.8%. Since April 2009, it has recovered significantly and is currently trading near $94 per share. If the fall of 2007 represented the pinnacle of “risk-ignorance”, what does the current price of HYG say about our aggregate level of common sense today?
At Bell Wealth Management, we believe that bonds should primarily be used for generating current income and for reducing risk in a portfolio. Spend the majority of your “risk budget” on the equity side of your portfolio. Today, you are more apt to be rewarded fairly over the long-term for taking risk in stocks versus bonds. If you are interested in hearing about our current fixed income strategies, please contact us for a personal and confidential meeting.