The attached article from Forbes, “Junk in the Trunk: The Story of Today’s Bond Market” was posted in June of 2019. At that time, the yield curve showed inversion for 6 month through 3 year maturities, with normal (upward movement for later maturities). In contrast, the current yield curve shows a modest, but steady, increase in yields based on bond maturity.
Keeping the quote from Reuters (below) in mind, discuss your thoughts on bond investing. How might you think about investing in bonds at this time (for consistency, let’s assume you have 30-40 years until you plan to retire). In contrast, what would you recommend to your parents or grandparents, who are closer to their retirement? What I am looking for here is a discussion of what types of bonds (think about the ratings as discussed in the Junk in the Trunk article) you might consider for yourself and if you recommend the same strategy, or something different to your parents/grandparents. What are the factors or conditions/expected conditions that are driving your bond investing strategies?
“Yield curve inversion is a classic signal of a looming recession. The U.S. curve has inverted before each recession in the past 50 years. It offered a false signal just once in that time. When short-term yields climb above longer-dated ones, it signals short-term borrowing costs are more expensive than longer-term loan costs.”
Source:
https://www.reuters.com/article/us-usa-economy-yieldcurve-explainer/explainer-countdown-to-recession-what-an-inverted-yield-curve-means-idUSKCN1V320S
Questions (minimum of 250 words per question)
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2,441 views | Jun 11, 2019, 09:00am
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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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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