3 More Warning Signs That a Seismic Shift in Bonds Is Coming

In the decade-long reach for yield, money has flown into longer-duration and lower-quality debt with little regard for the underlying risks. The aforementioned historically high leverage, exposure to floating rates and weak covenant quality notwithstanding, corporate bond yields have been tightening to near record lows over risk-free Treasuries as competing buyers demand less and less compensation for taking credit risk. Bonds in the ICE BofAML high-yield index are yielding an average of just 3.7% more than comparable Treasuries, up from a post-crisis low of 3.2% at the end of January.

Bond funds, especially passive ones, have driven much of the demand for new debt over the last decade. Federal Reserve data shows that mutual funds and ETFs have gone from owning just over 6% of the corporate bond market at the end of 2008 to almost 20% at the end of 2017. Over the same period, passive products have more than doubled as a share of total taxable bond fund assets, according to Morningstar data.

There are two problems with passive and marginally active funds driving an increasing share of bond buying. Like equity index funds, the underlying buyers are inherently price-insensitive.  But unlike equity index funds, which are weighted by market cap and are thus skewed toward larger and ostensibly higher quality companies, bond indexes are weighted by the amount of debt issued. As a bond indexer, you’re lending the most money to the companies that issue the most debt, leaving the index skewed toward issuers with the most leverage.

In aggregate, we think investors in high-yield bonds today are being poorly compensated for risks in the next several years. We agree with the Bloomberg columnist Nir Kaissar, who said, “For that to change, high-yield bond markets will have to become a lot scarier than they have been in recent weeks.”

Silver Lining

It’s not all dark clouds on the horizon, though — savers in money markets and CDs will benefit from rising rates, as will patient buyers of high-quality bonds. While bond prices and interest rates are inversely related in the short run, starting yield is also the single best predictor of future long-term bond returns. The same Bloomberg piece showed a high correlation between starting yields and subsequent 5- and 10-year returns for both high-yield and emerging market bonds. This makes intuitive sense — assuming no defaults, a 10-year bond purchased at a 2% yield to maturity will, by definition, average 2% nominal returns over the next decade despite any intervening price fluctuations, while the same bond purchased after a rise in rates at a 6% starting yield and held to maturity will average 6% nominal returns. As rates return to more “normal” levels (a nebulous concept, but materially higher than 0%) and the underlying risks in the bond market are exposed, I think we’ll begin to see a return to more rational risk/return dynamics, as well as significant mispricing opportunities.

The best advice I can give my fellow fixed income investors is to know what you own. Whether it’s individual issues or a bond ETF, take the time to understand the underlying credit and interest rate risks. Avoid long-duration assets if your portfolios can’t tolerate significant volatility. Stay clear of highly levered companies that will be most heavily impacted by the end of cheap debt.  When the fault lines shift and the ground starts to shake, make sure your investments are already firmly anchored.

— Check out 2 Warning Signs That a Seismic Shift in Bonds Is Coming on ThinkAdvisor.

Mark is a co-founder of Intrepid Capital. He is also the lead portfolio manager of the Intrepid Capital Fund, the Intrepid Disciplined Value Fund, the separately managed Intrepid Balanced and Intrepid Disciplined Value portfolios and the Intrepid Capital, L.P. He has over 30 years of experience in asset management. Mark received his B.A. in economics from the University of Georgia. Travis serves on the Board of Trustees of The Bolles School and the Board of Directors of Jacksonville Clay Target Sports. He is also a member of the Ponte Vedra Rotary Club and YPO-WPO.