Terry’s Columns Beware of Bonds

Beware of Bonds

By Terry Savage on February 19, 2020

The stock market has been getting all the attention in recent months, but the bond market has been getting a larger share of the investment dollars. The attraction is the higher yields and presumed safety of bonds. But those lures may prove to be a costly illusion when the next financial crisis arrives.

The flow of funds into bonds has been dramatic. According to the latest Morningstar statistics, in 2019 taxable-bond mutual funds and exchange traded funds took in a record $414 billion in new investment dollars – while investors sold $72 billion in stock market mutual funds and ETFs.

In fact, in the past ten years investors have poured $2.68 trillion into investments, with 74 percent of that going into bonds. While the stock market has made headlines, corporate and municipal borrowers (not to mention the U.S. government) have been easily able to capture the liquidity to borrow money at relatively low yields.

Meanwhile, the quality of the bonds being offered has diminished. That is, investors seeking yield are willing to buy bonds of lower-rated corporations, which must pay a slightly higher return.

Bonds sold in the public marketplace are subject to a rating system. Top quality bonds are rated AAA (“triple A”), and the ratings scale for “investment grade” bonds goes down to BBB. Most pension funds and bond funds are required to hold only investment grade bonds. The problem is that a growing proportion of investment grade bonds are being issued at the lowest, BBB, rating tier.

Today, 50 percent of “investment grade” bonds are rated BBB — versus 35 percent in 2006. In fact, over the past 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion, an all-time high.

That means those “safe” bond funds are likely stuffed with lower quality investment-grade bonds as the fund managers search for a bit more yield to attract investors. But what happens when the economy slows or moves into recession?

Bonds in a recession

According to Moody’s, 10% of BBB-rated corporate bonds are downgraded to “junk” status in a recession. And when that happens, the holdings no longer meet the investment-grade criteria for the fund or pension, and must be sold. And when that happens, bond prices will drop dramatically.

In this situation, investors can lose just as much money in bonds as they can in stocks, when selling drives prices and valuations down. And if you’re using a bond fund to generate liquidity for retirement withdrawals, you could be forced to sell your bond fund shares at a loss.

Choose bond funds wisely

The increase in bond investments can be seen as an intelligent reaction to rising stock prices. Investment advisors “re-balance” their clients’ funds, taking some money out of stocks as prices rise, and reinvesting in safer bonds and bond funds.

The real trick is looking “inside” those bond funds and choosing only those with a larger proportion of A-rated bonds, or better. But even that doesn’t guarantee against falling prices of bond funds, at least for a while.

And if you own a “high-risk” or emerging market bond fund – or even the municipal bonds of a state or city that is at risk of not collecting enough taxes in a recession – then you should be prepared for even larger losses on price, or perhaps on defaults in a serious economic slowdown.

Of course, the goal is to ride out any market decline. A recession is bad for most companies, and their stocks suffer. Bond prices fall too, more dramatically if there is any doubt that the company will not earn enough to pay the promised interest rates.

Bonds do have a higher claim than stocks on a company’s assets in case of a bankruptcy. But that’s truly a worst-case scenario.

A financial crisis may even offer the opportunity to buy corporate bonds at a very cheap price – if you have the cash to do so.It’s tough to hold onto cash, waiting for that kind of opportunity. Most people would rather have the higher yield of a bond or the upside potential of a stock. That’s what’s driving both markets today.

While everyone’s watching the stock market for a signal, the bond market might prove the most painful investment vulnerability. And that’s the Savage Truth.



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