Record low interest rates on riskier corporate bonds are prompting money managers to look far afield in a bid to boost returns.
Faced with yields once reserved for the safest types of government debt, some managers of speculative-grade bond funds are piling into debt with rock-bottom credit ratings. Others are buying smaller, more obscure securities that carry higher yields because they can be hard to sell.
No strategy is likely to be entirely satisfying because of the recent low-rate environment. The average speculative-grade U.S. corporate bond yield reached as low as 3.53% this summer, more than a percentage point lower than it had reached at any time before the Covid-19 pandemic, according to Bloomberg Barclays data stretching back to 1995. The average extra yield, or spread, that investors demand to hold low-rated bonds instead of ultrasafe Treasurys is near a record low.
Low yields present challenges to all fixed-income investors, including those who buy higher-quality, investment-grade bonds. Low yields cause particular anxiety for high-yield-fund managers, given that buying the wrong bonds can mean dealing with defaults and drawn-out bankruptcies, not just lagging behind benchmark returns.
An informed client is “more tolerant and they understand that this is the kind of market you almost want your manager to underperform,” said David Knutson, head of credit research for the Americas at Schroders, the U.K. asset- management firm.
Still, he said, there are broad pressures on managers to outperform their benchmarks. Accordingly, for much of the year, many have been piling into the lowest-rated speculative-grade bonds—those rated triple-C or lower. This buying spree has driven yields down so far that purchasers have rarely been compensated less for taking risk.
At the start of the year, investors could obtain 2.79 percentage points of additional spread by buying triple-C bonds rather than those rated one tier higher. By July, that was down to 1.51 percentage points—the lowest over the past 20 years other than a brief period in 2007.
My response to all of this is "just say no." After years, arguably decades of aggressive government manipulation of interest rates to its own advantage, causing huge distortions in the broader financial markets, we have reached a point where we can make a few observations...
- The Untied States Government is running levels of debt as a percentage of GDP that have no historical precedent.
- The government is, and has been for years. forcing down interest rates in the bond market, thereby facilitating the government's unrelenting apatite for debt.
- The government is printing money like water.
- The government is spending hundreds of billions of that newly created money to buy its own bonds, at hugely depressed rates.
- All of the newly created money, in combination with the largest ever peacetime expansion of government spending, is sparking a sharp uptick in inflation, to the point that...
- Bonds now carry a de facto negative yield, no matter the credit quality or the duration of the bonds in question. This means that if you are buying a ten year US Government bond, currently yielding around 1.3%, with inflation at 5.4% as of July 2021, you are taking a 4% loss in the value of your investment right out the door as a consequence of currency debasement and lost purchasing power. Or, to put it in plain English, you are paying the Federal Government around 4% for the privilege of lending them money. In order to avoid a loss on that bond before it matures in ten years, inflation would have to drop to near zero or actually go negative for a prolonged period of time.
- The technical term for what we are seeing is financial repression. In this economic environment savers and those investing in fixed income securities are all but guaranteed to lose money when adjusting for inflation.
Broadly speaking; my view is that bonds have become exactly what they are not supposed to be, i.e. high risk and no return. That's not something I am interested in.
(In the interest of full disclosure, I have almost no holding in bonds or any other fixed income securities.)
This raises a lot of questions, like where to invest or even just park money that you don't want to lose value? The stock market has been booming, the S&P 500 seems to be setting new records near daily, which makes me nervous. Valuations are also at all time highs as measured by the price to earnings multiple. A lot of this is likely investors looking for something with actual value that won't be crushed by all the money printing. Though some is also undoubtedly a response to the improvements in the economy after last year. But the stock market is fickle and what it gives it can take away with often breathtaking speed and brutality.
For now I'd look at hard assets in preference to bonds. Real estate/land, commodities, and precious metals. Right now I'd take gold over a 30 year US bond any day of the week and twice on Sunday.
But, unless you are anticipating a long term deflationary depression, in which case anyone buying bonds right now will look like a financial genius in five years; I don't see a realistic argument for owning securities that start losing value from day one, and likely will continue to do so for the foreseeable future. If/when bond yields are allowed to rise a few percentage points above inflation I may reconsider. But until then buying bonds as an investment or to save money is a bit like buying a car, and hoping you will be able to resell it in ten years for what you paid for it today.
Of course if inflation gets bad enough, that might be possible, on paper.
