Published — Tuesday 25 December 2012
Last update 25 December 2012 1:27 am
NEW YORK: Proving yet again that history rhymes rather than repeats, just a few short years after an epochal crash the search for yield just gets wilder and wilder.
Perhaps the best place to see this is in the corporate bond market, where yields are at or near all-time lows while, by some measures in key sectors, investor protections have never been weaker.
Don’t expect, though, to see a repeat of the bloodbath of 2008 and 2009, when markets froze and there was real fear that normally viable companies would as a result hit the shoals. For one thing, companies are more liquid and less leveraged.
Instead, the big risk for 2013 is that higher overall interest rates make bonds issued in 2012’s rock-bottom rate environment into big, but not catastrophic, losers.
Corporate borrowers have been a prime beneficiary of monetary policy, as trillions of Federal Reserve bond buying freed up money which then sought higher, if not safer, returns elsewhere. That, indeed, was part of the plan, and investors have streamed into riskier and higher yielding corporate bonds.
Little wonder, given that many investors, particularly pension funds, have yet to sufficiently recalibrate their annual return goals to suit a low-growth, low-return world. If you are going to hold a third of your portfolio in fixed income, but hope to make 8 percent overall, the only way to do it with 10-year Treasury yields at 1.78 percent is to take on a whole lot of extra risk.
Many have also talked themselves into thinking that the best companies are the new sovereign credits, using the crisis in Europe and the downgrade of the US as an argument for re-allocating into high-rated corporate debt. Stop me if I am wrong, but last I checked even the best-rated corporation hasn’t got either a printing press to create money or the power to impose taxes.
The numbers coming out of the corporate bond market are striking.
The yield on the benchmark BofA Merrill Lynch US Corporate Master index was last seen at a measly 2.84 percent, near life-time lows set earlier this month. The yield on the BofA Merrill high-yield index of the bonds of riskier companies was just 6.23 percent, an all-time low.
On a spread basis, which measures the compensation investors get above what Treasuries pay, things are not quite as bad. For high-yield bonds, spreads are 5.19 percent, well above where they were during the boom years in the early part of the last decade. For high-grade corporates the spread, while only about 1.5 percent, still compares favorably to the 1 percent or so that prevailed before the crash.
Many argue that companies represent less risk than before the crash, and on some measures that is true. Leverage, outside of certain narrow segments, is generally lower, and companies have learned the lesson of the crash, cleaning up their balance sheets and maintaining better access to cash and working capital.
The big difference between now and then, however, is market interest rates. Before the crash so-called risk-free Treasuries had much more symmetrical risk, meaning there was plenty of room to rally as well as plenty of room to move against investors. Now, unless you believe rates will go negative, overall risk is skewed against investors.
Fitch Ratings recently estimated that the average 10-year BBB-rated US corporate bond issue would lose 15 percent of its value if Treasuries only rise to where they were in early 2011, about two percentage points higher than currently. Even a one-point rise in rates would shave 8 percent off of the value of the same bond.
High-yield bonds will show negative returns in 2013, according to veteran high-yield analyst Martin Fridson, of FridsonVision LLC, who bases his call on the market’s expectation of rising Treasury yields next year.
“The difference between the high-yield return and the five-year Treasury return in environments like the present one has averaged negative 2.17 percent,” he wrote in a note to clients.
Even if you don’t believe market rates will move higher, there is plenty to be worried about in the riskier segments of the corporate bond markets, where issuers have taken the opportunity to again winnow away the strictures that have traditionally protected investors. According to ratings agency Moody’s the quality of covenants, limitations outlined in a bond to protect the interest of creditors, was at a record low for bonds issued in November.
Any sensible investor will demand more security for taking more risk, right? Not in the high-yield bond market of 2012, she won’t. Reversing a trend which has to be seen as the natural order of the universe, in parts of the credit spectrum the lower the borrowers rating the worse covenant protection became.
For corporate bond investors 2013 looks likely to rhyme with 2008, though it will be a downbeat dirge rather than the funeral march of the crisis.
— James Saft is a Reuters columnist. The opinions expressed are his own