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Are Bonds Over Loved?

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David G. Dietze, JD, CFA, CFP
Sep 22, 2009
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During the height of the financial crisis last fall, investors dumped assets of all stripes and rushed to the perceived safety of US Treasury debt; the ten year Treasury’s yield fell to nearly 2%, while the yield on 90 day Treasury bills actually went negative.

The rush from risk to safety left both stocks and non Treasury bonds at bargain basement levels. Longer dated municipal bonds offered yields of nearly 7%. Investment grade bonds sported eye popping yields of nearly 9%, while the risky high yield (junk) bond market saw yields rise to a record 22% on average.

Investors, as fear receded, quite rightly saw better opportunities in corporate and munis relative to equities. While bonds never have quite the same potential as equities, the risk is far lower. With yields so rich, investors reasoned they could get equity like returns with significantly less risk.

The message spread and investors have invested $214 billion into bond mutual funds since March 1, far more that the $113 billion received by such funds in the prior bull market from 2003 to 2006. Returns have been nothing short of phenomenal, with corporate bonds performing nearly as well as the S&P 500, while high yield bond funds have run rings around the S&P 500; Fidelity’s High Income fund sports a 41% return year to date versus the S&P’s 18% return.

Unfortunately, the corollary to the big run up in bond prices is a big fall in their yields. Yields on municipals now are in the 3% to 3.5% area, high quality corporates have fallen to 4%, while junk bond yields are down to nearly 8%. Meanwhile, as those yields have declined, the yield on credit risk free Treasuries has risen, with the ten year Treasury’s up to 3.4%. That means the all important spread, meaning the extra yield available over a comparable maturity Treasury has shrunk dramatically in a very short time.

With the lower yields, bond’s risks have increased substantially.

Bottom Line

Corporate and municipals have had ferocious runs this year. Indeed, when you factor in their lower risk, on a risk versus return basis this has been the sweet spot for investors. This opportunity has not gone unnoticed, as mutual fund investors have poured billions into bond funds.

However, the lower yields and heavy demand have raised their risks, which include rising interest rates, looming inflation, and lurking credit issues.

Consider shortening maturities to reduce the risk of rising rates. Bonds whose principal adjusts with inflation, together with equities whose dividends can increase, can help reduce inflation risk. Treasuries are an antidote to credit risk.

Fund Investors Show an Insatiable Demand for Bonds

More money has found its way into bond mutual funds this year than in the bull market from 2003 to 2006. Mark Hulbert writing for MarketWatch notes that in the last bull market investors had an overwhelming preference for equity funds, but this year investors much prefer bond funds.

Consider that from 2003 to 2006 equity mutual fund inflows totaled $283 billion, outpacing bond fund investments, which garnered just $113 billion. This year, however, starting in March nearly $20 has been invested in bond funds for each $1 received by equity funds; indeed, total contributions to bond funds have reached a staggering $213 billion. And this is despite the fact that equities have had a great run, up a phenomenal 57% since March 9.

Unfortunately, this rush to bonds has negative implications for their future returns. Historically, when a market sector sees lots of buying, prices rise, but later, as interest cools, prices start to fall, leaving those who bought in at the top holding the bag.

Mr. Hulbert cites an influential paper ( "Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability" in the September 2007 issue of the Journal of Banking and Finance by Friesen and Sapp) as providing carefully documented support for this tendency. Fund investors typically get in and get out late, buying high and selling low. These huge fund investments are a contrarian warning signal, suggesting bonds could be vulnerable. 

Interest Rates Dropping Fast

Bonds are much riskier today than at the year’s start since their prices have risen, translating into much lower yields. The lower yields provide less cushion to offset risks and less competition to other asset classes, like stocks, commodities, and money market funds.

Examine bond yields relative to Treasuries. Just before the market’s downturn in 2007, high yield bonds returned just 2.7% over Treasuries with comparable maturities. With 20/20 hindsight, junk bond investors were not being compensated for their risks.

By December 2008 that spread had widened to 20%, the largest on record. This year, as junk bond yields have declined and Treasury yields have risen, the spread is less than half of December’s.

As the spread narrows, at some point bond investors will again conclude that the extra yield does not warrant the extra risk. 

Key Risk: Rising Rates

If interest rates rise, existing bonds get marked down in value. Who wants the old bonds with a lower yield when newly issued ones offers better rates?

The longer dated your bond, the more risk you court. That’s because you’re locked into the lower old rates longer before the issuer must repay you.

Check a bond’s duration to determine the degree of risk. It measures how long it’ll be before receiving your principal and interest. The rule of thumb is that a 1% rise in interest rates will produce a decline in its value equal to its duration. 

The bottom line is the greater the bond’s duration, the greater your exposure to rising rates. Of course, higher duration bonds typically yield more, to help compensate for the risk. Further, if rates decline you’ll profit, with the duration formula working in reverse.

Will rates go up? No one knows for sure. However, on an historical basis yields are low. Compare the double digit yields that prevailed in the 1970s. Further, an economic recovery tends to cause rates to rise, as more loans are demanded and monetary authorities reduce credit availability to counter possible inflation.

Now that yields and spreads over Treasuries are so much lower, bond investors must be particularly cautious of rising rates.

Inflation Can Devastate Fixed Income

Bond interest has two components. One portion compensates for deferring the enjoyment of your money; the other for the reduced purchasing power you’ll face when your money is repaid.

When inflation increases, what you thought was sufficient compensation for inflation may prove insufficient. As a result, interest rates will rise and your bonds will lose value.

Inflation now seems distant. The biggest component of consumer prices is labor. With unemployment rates at close to a 25 year high, the prospect for raises seems slim.

Nevertheless, we have seen massive inflation in financial markets this year. This spurs confidence and economic activity. This ultimately will put pressure on all resources in the economy, including labor.

Further, it’s not just the cost of goods and services produced domestically that we have to worry about, but also those coming in from abroad. Such trading partners as China and India never fell into recession, so cost pressures there never abated as much. That could cause import prices to rise.

Further, the US Dollar is at a one year low. Many believe the US Dollar will sink further. That would translate into higher import costs. 

The bottom line is with yields so much lower than at start of the year rising inflation poses significant risks.

You’re Less Well Compensated for Credit Risk

Corporates and municipals yield more than comparable maturity Treasuries to compensate for the greater default risk. At the start of the year bond investors were extremely well compensated for that risk; today, much less so. 

Is the risk that much less than at the start of the year? Are we out of the woods when it comes to the Great Recession? Certainly, our current unemployment rate of 9.7%, given that consumer spending is nearly 70% of the economy, suggests not.

In addition, unforeseen events could also derail the economy, causing defaults to soar. Geopolitical conflict, terrorist attacks, or any health pandemic could wreak havoc. 

Unfortunately, as yields have fallen and spreads have tightened, there’s much less of a cushion to absorb this risk.


To hedge corporate and municipal bond risk, investors have several options. One is to head for US Treasuries. You avoid any credit risk, and yields are superior than at the start of the year. However, you will not duck the risk of higher interest rates and inflation. 

Shortening your maturities reduces the risk of higher rates.

Consider TIPS, a/k/a Treasury Inflation-Protected Securities. Like regular Treasuries, there’s no credit risk. As their principal adjusts with inflation, you offset inflation risk. While exposed to the risk of higher interest rates, to the extent higher interest rates are a product of increased inflation, you’ve reduced interest rate risk. 

Another approach is to seek out high dividend paying stocks. While dividends can be cut or omitted, they typically rise over time, helping to offset purchasing power loss. 

Utilities are traditionally strong dividend payers, feature low volatility, and may be considered worthy bond substitutes. They also have the virtue of having done little in the recent stock market run up. Consider Verizon, owner of the largest wireless network in the nation. It pays a dividend of 6.4%, and serves 30% of the country. 

Electric utilities merit attention now. Dominion Resources (D, Financial) boasts diversified fuel sources to generate electricity and over 30 million rate payers in Virginia and North Carolina. It currently yields 6.4%. American Electric Power (AEP, Financial) yields 5.1% and enjoys a service territory that spans 11 states, thus minimizing the adverse action of any one regulatory board. Public Service Electric & Gas (offers a generous yield of nearly 4.2%; the company has become increasingly efficient in the wake of its failed merger with Exelon.

In short, investors have several options to mitigate the risks to their bond portfolios

Best Regards

David G. Dietze, JD, CFA, CFP™

President and Chief Investment Strategist

Point View Financial Services, Inc.

Summit, NJ

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