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January 01, 2011 at 07:00 PM
In his famous hit song “The Gambler,” Kenny Rogers explains you got to “know when to hold ‘em, know when to fold ‘em.” But knowing the ideal time to exit a game of cards or a trade or an investment is something everyone would like to know, not just gamblers.
Given that bond prices have surged and yields are slim, is it time to ditch bonds?
Today’s bond market favors sellers, not buyers. Knowing this, U.S. corporations, like the government, have been issuing new debt in the form of bonds at a record pace.
Around $332 billion in corporate debt has been issued during the third quarter alone. Even companies with a spotty credit history are having an easy time finding buyers for their debt. As borrowing rates have dropped, prices for junk bonds (HYG) over the past year have jumped 14.85 percent.
Moody’s Investors Service estimates the default rate on high risk U.S. corporate bonds will decline below 3 percent by year’s end. Their default rate tracks the percentage of companies with junk rated debt that missed bond payments during the preceding 12-month period. During the final half of 2009 the default rate was at 14.60 percent.
Even with today’s lower default rates, the corporate borrowing binge will eventually have a cost. All of the record debt that companies are racking up today will have to be paid. And as Warren Buffett once quipped, “Debt is a four-letter word.”
Accepting Low Yields
During the fourth quarter, the U.S. government had no problem selling $36 billion in two-year Treasury notes yielding just 0.441 percent. Oddly, record low yields didn’t faze bond buyers one bit. And so long as the U.S. government can obtain cheap financing from eager buyers of its debt, it can continue running up multi-trillion dollar deficits without incident.
Short-term government bonds (SHY) with maturities of 1-3 years have a 30-day SEC yield of just 0.26 percent. In contrast, investment grade corporate bonds (CSJ) with similar maturities are yielding almost 90 basis points more. The SEC’s yield calculation takes into account the interest earned during the most recent 30-day period after deducting the fund’s expenses.
The mentality of today’s bond investor has drastically changed. The traditional view of investing in bonds for yield income has been replaced by investing in bonds for capital protection. Meanwhile, little thought has been given to interest rate risk and issuer credit risk.
There are many warning signs in today’s overheated bond market. Record low yields favor debt sellers, not debt buyers. Also, increasing debt loads for both corporations and the government will come back to bite them and the individuals that financed them once the current cycle of over-borrowing fizzles out. No doubt, most of Wall Street’s credit analysts and bond underwriters are still forecasting blue skies ahead. Should we expect anything less?
If your clients have enjoyed the run-up what should you do? Evaluate their portfolio to see if certain bond positions have suddenly become a disproportionately large part of the portfolio and rebalance the bond portion back to its original target asset allocation.
