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Junk in the Trunk: The Story of Today’s Bond Market

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The Story of Today’s Bond Market

Stock Market Gets The Glory, But Bonds Are a Brewing Mess

Bond investing is more than meets the eye. Like a car that looks nice on the outside and the interior is pretty comfy. Check the trunk of this particular vehicle, however, and you see a hidden risk. There’s plenty of junk there. It is an issue to grapple with in the months and years ahead, for both investors and their financial advisors.

I will admit that I find myself thinking a lot more about the bond market than I am used to. After all, bonds have essentially been in a bear market for 2 years, after a bull market that lasted about 35 years (1982-2017 by my count). Recently, U.S. Treasuries have been a nice way to diversify from stocks, as interest rates dropped quickly. But the ceiling for Treasury Bond returns is very low.

Bond returns: the future is limited

After all, the 10-year bond yields just over 2%. That means if you buy a bond now, you are getting around 2% in income each year, plus or minus the price change of the bond. Sure, yields could drop to zero, or even go negative (but please, let’s not deal with that right now). But there is not much room to add to that 2% income return.

Now, if the bond were yielding 5%, you would have a higher return to start with. And, if interest rates headed south, you could make additional return from that. And, you would have more room for rates to fall from 5% than you would from 2% in the example above.

The risk of “reaching for yield”

This is the kind of logic that causes many investors to make a decision that seems like no big deal. But it can cost them dearly. This is especially the case if they are close to retirement. It is the urgency to “reach for yield” by investing in the types of bonds that glitter with higher interest rates than high-quality bonds offer. However, the risk these so-called “junk” bonds carry are at a historically high level. In fact, I would judge the risk of having a large chunk of your portfolio in U.S. Corporate Bonds rated BBB or BB or lower to be as high as it has been in my 33-year investing career.

The health of the corporate bond market has deteriorated markedly over the past few years. This is due to a combination of factors. The one that sticks out to me is how bond funds have been stuffing themselves with securities that are just above “junk” status. That is, they are rated BBB. Bonds rated BB and below are considered high-yield i.e. junk bonds.

These funds are owned by millions of unsuspecting investors. On their own or through financial advisors, they have sat happily with bond funds or individual bonds that yield 2-3% above Treasuries of the same maturity length.

As the chart below shows, those “spreads” of the BBB and BB bonds over Treasuries are historically low. I have also shown you the 1-year returns (rolling) of the high yield bond ETF (HYG) and the investment grade corporate bond ETF (LQD), the latter of which has about 50% of its holdings in BBB-rated securities. That is high, much higher than in the past. Going forward, this is one of many factors that have conspired to make corporate bond investing treacherous.

When risk becomes reality

Low spreads in BBB and BB bonds may be followed by big losses. Watch out.

You can also see how prices of BB’s dipped over 25% during the financial crisis, while bonds rated AA-BBB fell over 15%. This would be a complete shock to bond fund holders if it were to happen again. Once the next recession creeps in, I think it will.

My intention is not to scare you. Gloom and sensationalism are not the objectives here. The intention is to bring light to what you don’t often hear amid the hype and blather of the financial media. Tomorrow’s major investors issues are often hidden today. Eventually, they bubble up to the surface.

I think this issue of U.S. bonds rated BBB and lower, at a time when recession concerns are rising, is one of those. When it will go from concern to wealth-destroyer is anyone’s guess. But the first step for any investor is to understand that it is a risk. Audit your current portfolio to see what risks it contains, and then see how tolerant you want to be of those risks.

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