Most investing experts recommend a diverse investing portfolio, with a split between equities (stocks) and debt (bonds). Some are adding commodities to the mix, and virtually everyone who can think about investing also owns a home and has some cash for a rainy-day fund (at a minimum) so people are also invested in real estate and short term cash.
The traditional view was that stocks are risky and that bonds aren't risky. Over time, stocks are expected to deliver a higher return than bonds, but they will move around more on a given year (have higher volatility) while bonds will give you a lower return but shield you from downturns. In future posts I will go through these assumptions in more detail, but for now let's assume that they are the common thoughts.
Bonds, however, are becoming far more risky. The US Government Treasury bond, which is essentially risk-free (if the US government defaults we all have REAL problems) is a proxy for long-term interest rates. These rates are currently low, let's say around 5%, and in line with what you get for short-term cash (i.e. in a money market account). This is due to an inverted or flat yield curve which is generally an unusual situation, since short term (cash) should generally pay LESS than long term bonds.
Aside from the US Treasury bond, which has zero default risk, an entire corporate bond sector exists where companies issue debt. Based on their credit ratings, an AAA borrower will pay only a fraction of a percentage point greater than a US Treasury security of equivalent length (i.e. a 20 year bond for both would ALMOST have the same interest rate). Lower quality borrowers, down to junk bonds, pay a couple of percentage points higher, to compensate for the risk of default.
However, default isn't the prime risk today - default generally occurs when the company has problems and begins to fall apart - the prime risk is actually INTENTIONAL ACTIONS TAKEN BY MANAGEMENT OR THE MARKETS TO REDUCE CREDIT QUALITY. By intentional actions, I mean:
- taking on a lot of debt (issuing new bonds) to pay out a big dividend to shareholders
- taking on a lot of debt (issuing new bonds) to buy back stock and reduce the # of shares outstanding, which increases earnings per share (EPS)
- taking on as much debt as the enterprise can carry and buying out all of the public equity, known as a leveraged buyout. Given that you can "lever up" a company to 8-11 TIMES their available earnings, these companies teeter on the edge of disaster right out the gate (i.e. if a major customer defects or commodity prices spike they could go under)
In today's Barron's magazine (I just bought an online subscription for $20 to go with my online subscription to the Wall Street Journal - this lets me find old articles and is recommended) there is an article called "Beware the Credit Bubble" which is an interview with a credit analyst. In the article they say that 1) risks are high that credit quality will fall for companies 2) investors are not being paid for this risk.
What To Do:
In the short term I would assume that your bond portfolio isn't as safe as you think. If you want income, you might want to park your money in short term cash since it currently is yielding as much as long term debt or government securities where there is no default risk.
Over time, the market gets things right. If these long term (20-30 year) issues have more risk than Treasuries, their price will fall and there will be a buying opportunity. I can't time stuff like this, just that people need to be aware that they are receiving only a TINY premium over zero risk debt for debt that, it appears, has a LOT of risk. Some companies mitigate the risk with covenants, and others are starting to put old-fashioned constraints on debt that require repayment. For instance, the debt covenant could demand a certain ratio of income to debt, and require immediate repayment if this limit is exceeded. This type of covenant basically requires the LBO buyer to take out all the existing debt and repay current bondholders, rather than just issuing piles of new debt and dragging the value of the existing bondholders' assets down WITHOUT COMPENSATING THEM IN ANY WAY, which is what generally happens today.
A lot of financial "experts" just repeat tired old sayings without thinking of whether or not they are relevant in today's financial world. The purpose of this blog is to examine assumptions and see if they are in fact true or require further analysis.
In this instance, I'd say the "safe haven" of corporate bonds as a counter weight to stock riskiness definitely requires further analysis.