October 12, 2012
Looking for guidance on how to play the bond market in this low interest rate environment? Don’t look to the pros – even they can’t seem to agree which is the worse threat, interest rate risk or credit risk.
On the one hand, Pimco’s Bill Gross has been cutting his holdings of Treasury securities for the last three months. In his view, the risk is that the country’s fiscal problems and the endless flow of stimulus money from the Federal Reserve will ultimately come back to haunt us in the form of inflation – and much higher interest rates – in the long run and erode investor confidence in Treasury bonds in the meantime. Unless the country addresses its fiscal situation, Gross argued in his October investment outlook, bonds will get “burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the ‘Ring of Fire.’”
On the other side, Jeffrey Rosenberg, the chief investment strategist for fixed income at BlackRock Investments, takes a more positive view of Treasury securities, at least in the short run. In a report to clients published yesterday, Rosenberg said he would suggest scaling back exposure to credit risk (in the form of corporate bonds) and mortgage-backed securities while increasing exposure to Treasuries, at least on a tactical basis.
The two aren’t debating the relative merits of their views face to face on national television like the presidential and vice-presidential candidates, but just as those politicians have done, the money managers illustrate a division of opinion over just how to approach what is an increasingly frustrating fixed-income market.
No one is eager to fight the Fed – and the central bank’s policymakers have made it crystal clear that they have no intention whatsoever of raising interest rates before 2015. Former Fed chairman Alan Greenspan tried to sway markets, and sometimes succeeded. Ben Bernanke’s Fed doesn’t have any intention of waiting to see whether the market will be persuaded.
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So, if low interest rates are going to remain a fact of life for bond investors, what’s the right strategy? Some bond market veterans point out that even in an ultra-low rate environment, it’s still possible to generate returns. The declines in interest rates may not be as dramatic in absolute terms, but a move from 1.72 percent to 1.68 percent in yield is still a 2.3 percent decline that will generate a reasonable risk-adjusted return for investors in the 10-year Treasury note. Anything that causes fear to rise in global markets will drive investors back toward safe haven investments like Treasury securities and push yields lower and prices higher. A move of just a few basis points today can have a similar impact to that of half a percentage point two years ago, as one bond investor pointed out to me recently.
Still, if you’re not comfortable with the ultra-low yields or you’re as worried as Bill Gross is about the consequences of the Fed’s monetary policy initiatives, you will want to shun interest rate risk. Then it all boils down to credit risk – the chance of bond issuers defaulting – and whether you’re getting paid enough for taking it.
It’s hard to find many bond investors satisfied with the risk/reward tradeoff today, as company after company is taking advantage of the ultra-low rates to refinance their existing debt. That’s great for corporate bottom lines; not so great for investors in their quest for yield. (It’s not great for job creation either, since many of the businesses aren’t using their savings to expand but rather to help buttress their balance sheets, pay dividends to investors or simply offset the downturn in revenues or profits by cutting their financing costs.)
Bond research firm Gimme Credit highlighted the problem yesterday in announcing its 2012 list of the “bottom 10” high-yield bonds. Pointing out that the high-yield bond market is already up 12 percent so far this year, while it only gained 4.38 percent for 2011 as a whole, the company argued that “prices are up across the board, with little distinction between likely winners versus heartbreakers.”
We can’t name all ten companies whose debt Gimme Credit believes is most likely to end up in the “heartbreaker” category (that information is reserved for the firm’s clients), but a few examples highlight their concerns. Some are companies whose businesses are facing cyclical or secular challenges, such as Arch Coal. The latter’s 7.25 percent notes due in 2021 may be yielding 9.7 percent, but the business risk is high, Gimme Credit’s analysts believe. Other companies have restructured their debt to take advantage of the current ultra-low rates: ClearChannel, for instance, “likely won’t grow into its capital structure in time to meet debt maturities” and its unsecured bonds have “significant value risk.”
The yields on these “high” yield bonds identified by Gimme Credit today range from a low of 6.1 percent to about 10 percent, with only one outlier scoring significantly higher, at more than 14 percent. In the past, that kind of credit risk would have been rewarded with yields in the mid-teens, but the decline in Treasury yields and the compression of spreads as nervous investors battle for every scrap of income they can find means that credit risk too often has been mispriced.
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There’s no perfect solution or easy answer. Even in the case of mortgage-backed securities – shouldn’t the Fed’s pledge to buy a lot of these buoy their outlook? – there is no simple decision, argues BlackRock’s Rosenberg. “Today, the Fed’s support is fully reflected in the price,” he says, with the market discounting any political uncertainty. “At today’s level of spreads, the risks outweigh the rewards.” That’s why he calls for taking an underweight position in mortgage-backed bonds.
Ultimately, it comes down to a personal call: Do you feel more comfortable today betting on an above-average degree of credit risk or the prospect that interest-rate risk isn’t properly priced in? Only when you have pondered that question, and factored in your own tolerance for uncertainty and volatility, can you decide whether or not you’re ready to side with Bill Gross and bet that the prospect of a few more percentage points of return in the short run may not be worth the risk.