Monday, December 17, 2012

Bond Market Update

I haven't written too much recently about bonds but it doesn't mean that I haven't been thinking about them.

Bonds have been stuck in a fairly narrow trading range for the past 6 months.  The yield on the10-year Treasury note, for example, has mostly moved in the 1.5% to 1.7% area since the end of May 2012.

Low interest rates almost by definition mean that investors have little margin for error.  If you were to buy the 10 year Treasury note today at 1.7%, and rates rise by 20 basis points to 1.9%, you will have earned essentially nothing for the year. If rates move any higher, of course, your total return will be negative.

Still, flows into bond mutual funds remain robust, and no one it seems is all that concerned about either credit or interest rates risks. New bond issuance in the corporate market remains robust, as corporations find today's borrowing rates just too attractive to pass up.

Floyd Norris wrote a piece in Saturday's New York Times on the one-sided bet that Corporate America is making with bond investors.

If rates rise, writes Norris, investors will be stuck with low-yielding bonds until maturity.  If rates fall, corporations will redeem their bonds early, and force investors to reinvest at even lower yields.

High yield bonds in particular seem a bad bet at this juncture.  Investors are getting puny yields in comparison for the risks they are assuming. Even high yield managers are getting worried about the outlook for next year (my emphasis added):

..corporate bond issuance in the United States has risen to record levels this year, and the average interest rate on high-yield bonds, also known as junk bonds because they are rated below investment grade, has fallen even more rapidly than have rates on higher-quality bonds. 

Martin Fridson, the chief executive of FridsonVision and a veteran high-yield market analyst, said he thought high-yield investors were likely to lose money in 2013, as declines in prices offset the interest income realized from the bonds. 

Meanwhile, Bloomberg is out with an article this morning discussing the increasing irrelevance of the bond rating agencies.

When S&P downgraded the debt of the United States in July 2011, many investors thought that yields on Treasury debt would rise as the market demanded more return in exchange for more risk.   Of course, just the opposite happened; Treasury yields are now 25% lower than they were at the time of the downgrade.

Apparently the experience of the U.S. government is similar to what is happening in the corporate bond market as well:

The global bond market disagreed with Moody’s Investors Service and Standard & Poor’s more often than not this year when the companies told investors that governments were becoming safer or more risky. 

Yields on sovereign securities moved in the opposite direction from what ratings suggested in 53 percent of the 32 upgrades, downgrades and changes in credit outlook, according to data compiled by Bloomberg. That’s worse than the longer-term average of 47 percent, based on more than 300 changes since 1974. This year, investors ignored 56 percent of Moody’s rating and outlook changes and 50 percent of those by S&P.