Bond holdings and market risk

1/2/2020 Junk In The Trunk: The Story Of Today's Bond Market

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Junk In The Trunk: The Story Of

Today's Bond Market

Markets

Aggressive Capital Preservation

Rob Isbitts Senior Contributor

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

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1/2/2020 Junk In The Trunk: The Story Of Today's Bond Market

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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

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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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