Why the party's ending for corporate bonds
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Associate Editor
David Stevenson Aug 13, 2010
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Stock markets worldwide have been very tricky in 2010.
If you've timed your trades well or picked the right stocks, you've probably made money. But if you've invested in tracker funds linked to the mainstream share indices, the chances are you're down on the deal. Most stock markets are now lower than they were at the start of this year.
Holding corporate bonds, though, has been a very different story. This year almost all investors here are showing a tidy profit.
But all good things come to an end. And for corporate global bonds, it looks like the party is now ending.
What are corporate bonds all about?
You may already hold corporate bonds in your portfolio. If you don't know anything about them, here's a quick recap. Corporate bonds are IOUs issued by companies to raise money. Lower-rated corporate bonds yield (the expected annual return as a percentage of the price) more than top-notch issues, reflecting the higher risk you take when you buy them. These IOUs pay a fixed rate of interest until maturity, when investors are due their capital back.
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Corporate bond investors rank higher in the pecking order than ordinary shareholders. So they could still get paid out even if the company's equity capital goes up in smoke. And it's much easier to trade in corporate bonds now the London Stock Exchange has created a market for private investors to deal alongside the big institutions.
So far this year, so good. Corporate bonds have been one of the places to be. In Europe they've returned around 7% in local currency terms, while over in the States the total return has been more like 12%.
And at first glance, the latest headlines seem happily upbeat about this continuing. "Junk bond issuance" - selling the lowest quality IOUs - "is on a record-setting pace this week", says Michael Aneiro in the Wall Street Journal, "with a flurry of new market offerings on Wednesday adding to the uncommonly high total seen in August". Investors have done well, while for businesses, borrowing has been easy.
In fact, it all sounds too good to be true. And whenever that seems the case in financial markets, it normally is. If you're a contrarian investor, it's enough to start alarm bells ringing.
Now's not the time to own corporate bonds
Although the market's cheerleaders pretend otherwise, investors and borrowers aren't on the same side. What's good for investors - e.g. a higher yield - means more cost for borrowers and vice versa. When companies churn out extra IOUs in record amounts as fast as they can, like now, they reckon they're onto a good thing.
But it also means investors are getting a poor deal. The yields they're now receiving are as low as they've been for years. Like the yield on top-rated European bonds which has dropped to just 2.95%, according to the FTSE Euro corporate bond index. Even BBB-rated - much lower quality - European bonds only pay 3.45% on average. Compare that with German government bonds, still the best quality eurozone sovereign debt. These are paying 2.42%. So there's almost no margin of error for anything to go wrong in the 'spread' between the top-rated single currency state bonds and those company IOUs.
As for the US, here's a chart of the yield on BAA corporate bonds - quality-wise, in the middle of the range - calculated by Moody's going back to the 1960s. At 5.75% it's as low as it's been for over 40 years. Since then, company borrowers have never had it so good.
Source: Bloomberg
No wonder some bond investors are getting jittery. A double dip in the global economy looks in store, as we've written about in Money Morning this week. That would be bad for company profits, and for the ability of many businesses to service their bond payments.
So those investors are starting to worry they're not being paid enough for the extra risks of holding corporate bonds. That means they'll demand higher yields as compensation. So prices will fall.
Starting in the US, corporate spreads over government bond yields are beginning to widen again. "A pullback wouldn't be a surprise given the weaker economic releases coming out", says Christopher Langs at Aviva Investors North America. "Investors will demand more attractive pricing, especially for lower-quality deals".
And once yields start rising, they could keep doing so for months. That's because sovereign debt yields generally look poor value too. We've just written about the dangers of holding gilts.
Yesterday, here's how hedge fund manager Nicholas Taleb summed up the potential perils of global government bonds: when governments get badly overdrawn, as now, they "need more and more debt to stay where they are", he says.
"They need to find new suckers all the time. And unfortunately the world has run out of suckers". Because governments can print money, "the risk comes from a rise in interest rates" - as investors worry about inflation and so demand higher returns - "rather than a default". In turn, this will force global corporate bond yields even further.
Now I'm not sure Taleb is quite right - yet. There are still some big buyers of corporate bonds out there. But it won't be long before all bond investors cotton on that they're being suckered. The message on corporate bonds is clear. At current yields, they're a high - and rising - risk bet, and junk bonds are the riskiest of all. Clearly, not buying them will stop you losing your cash. But you can make money here too.
How to profit from the fallout
The iTraxx Crossover Five-year Total Return Index gauges the default risk of 50 of the most liquid European high yield corporate bonds. As investors' fear of default falls, junk bond prices rise. So the index climbs - it's almost at its highest since Bloomberg data began in 2006.
Now there's an ETF that's the inverse of the index - the db x-trackers iTraxx Crossover Five-year Short Total Return Index ETF (GY: XTC5). If junk bond prices drop, the index falls. So this ETF then rises because it's effectively selling the crossover index 'short'.
It isn't risk free. You lose money if the index increases. Nor is it simple - you can read about it here. This ETF is quoted in Frankfurt and quoted in euros, so there's currency risk if the pound moves up. But if the corporate bond boom is ending, this could be a way to cash in.
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