Off the Charts: Risk Creeps Up in Long-Term Bonds

Fed officials do not think that will happen until late 2015, but they could be overly pessimistic. A year ago, they thought that the rate would not get as low as it is now until 2014.

The prolonged low level of interest rates — both short-term rates that are administered by the Fed and longer-term rates that are more subject to market forces — has caused many investors to search for yield by purchasing longer-term bonds.

That has provided a bonanza for companies in the United States and in many emerging markets, where the amounts of newly issued bonds have risen rapidly.

“Almost any kind of corporate activity is acceptable to the bond market,” said Michael Shaoul, the chief executive of Marketfield Asset Management. “That is really a sign the bond market is becoming indiscriminate.”

For a bond investor, there are two things that can go wrong. The first is credit quality, when bonds either default or at least fall in market value because a default seems more likely. The second is interest rate risk — the risk that market interest rates will rise significantly.

Mr. Shaoul said he thought investors in emerging market bonds were more likely to run into credit problems, while American bond buyers were more likely to face interest rate problems as the American economy improved.

“Five years down the road,” he said, “you are likely to have significantly higher interest rates.”

For a bond market investor now, the choice is to stick to shorter-term bonds, and get very low yields, or to move to longer-term ones that pay higher interest rates but that could lose market value if the interest rate offered on new bonds rose.

Much of the recent issuance in bonds has been because of refinancing, in which companies repay existing bonds with money borrowed on better terms. For holders, it can seem the worst of both worlds: if rates rise, they have old bonds that have lost value. If rates fall, their old bonds are redeemed by the company, depriving them of the yield they expected.

As can be seen in the accompanying graphic, corporate bond issuance in the United States has risen to record levels this year, and the average interest rate on high-yield bonds, also known as junk bonds because they are rated below investment grade, has fallen even more rapidly than have rates on higher-quality bonds.

Martin Fridson, the chief executive of FridsonVision and a veteran high-yield market analyst, said he thought high-yield investors were likely to lose money in 2013, as declines in prices offset the interest income realized from the bonds.

His model says the yield spread between the Bank of America Merrill Lynch High Yield Master II index and similar Treasury securities should now be around 6.5 percentage points, based on historical spreads as well as economic conditions, current default rates and the relative availability of bank credit. The actual difference, as shown by the chart, is about 5.3 percentage points, which he thinks is not enough to offset the risk.

Floyd Norris comments on finance and the economy on nytimes.com/economix.

Article source: http://www.nytimes.com/2012/12/15/business/risk-creeps-up-in-long-term-bonds.html?partner=rss&emc=rss