Don’t get sucked into buying junk bonds

The most important interest rate in the world is getting higher by the day.

The yield on a ten-year US Treasury hit a two-year high of 2.87% on Friday. In other words, it's getting ever more expensive for the US government to borrow money.

Bond fund managers have been falling over themselves to explain why this doesn't mean bonds are a busted flush.

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While prices for government bonds have been falling, junk' bonds bonds with low credit ratings - have shrugged off fears of rising rates.

But don't get sucked in they're called junk' bonds for a reason after all

Foreigners don't want to keep lending to the US

As John Plender points out in the FT this morning, since 2000 there have only been ten months in which foreigners were net sellers of US long-term securities'. But foreigners have been selling America for five months in a row now. That is "a unique event in the past three and a half decades", says Plender.

It largely boils down to the taper'. In May, US central bank boss Ben Bernanke gave investors a nasty shock when he warned that he might stop being so free with the printing presses. Rather than pump $85bn into the market each month, he might print a bit less.

That frightened investors in both stocks and bonds. Basically, if there's less money being pumped into the economy, then there's less money available to pump up asset markets.

And a couple of figures stand out in particular, as Plender notes. "In June the two biggest holders of foreign exchange reserves in the world became net sellers of US government IOUs." In other words, China and Japan both sold US Treasuries. And they sold a lot of Treasuries June saw the biggest withdrawal of foreign money since August 2007.

You could be forgiven for thinking this is a false alarm. After all, the US Treasury market has looked astoundingly overvalued for a very long time. However, it's not just the scale of the Chinese and Japanese withdrawal that suggests something bigger. It's the general reaction of bond fund managers too.

They are clearly getting the jitters. The big bond fund managers are now rapidly issuing updates explaining to clients that they really can still make money from bonds in a rising interest rate environment they just need to change the sort of risk they are taking.

Bill Gross probably the most famous bond manager in the world released a somewhat laboured First World War analogy, arguing that bond investors have to change tactics. Other managers have made similar points.

The rough argument is as follows. Bonds carry a variety of risks. The most obvious particularly when it comes to developed world government bonds is maturity' risk. To cut a long story short, this is all about how sensitive a bond is to changes in interest rates.

A change in interest rates will have more effect on a ten-year bond than on a one-year bond. Why? Think about it. If you can lend £100 to someone with an impeccable credit rating today, and get £104 in a year's time, you'd probably think that's a reasonable deal. It's unlikely that in the next 12 months, something is going to happen to make that look like appallingly bad value for money.

But if you had to agree to make the same deal for each of the next ten years, you'd think a lot harder about it. Getting £4 a year for a £100 loan might seem OK today by comparison with a lot of deals out there. But with interest rates looking set to rise, you'd think very carefully before you locked it in for ten years.

In other words, if you want to borrow money over a longer period of time, when interest rates are rising, or threatening to rise, then you're going to have to pay more to do it. So the longer it is until a bond matures' (repays its original capital), the harder the price is hit by rising rates.

That makes the case for selling bonds seem rather open and shut interest rates are rising finally, so get out of bonds fast.

The new bond strategy buy the rubbish stuff

But it's not quite that simple, say bond fund managers. You see, there are other types of risk out there. And one of them is credit risk.

If you lend money to the US or the UK, then you can guarantee you'll get your money back. Inflation may well mean that it's not worth anything like as much as it was worth when you gave them it in the first place. But because they control their own currency, there's no way they'll actually default on the loan unless they choose to.

It's not the same for companies, however. Even the biggest company could feasibly go bust. So when you lend to a company (and to any government that isn't borrowing in its own currency like the peripheral eurozone economies), then there's always the risk that they'll go bust, and not pay you back. This is credit risk.

Because of this credit risk, investors will almost always demand a higher interest rate when investing in corporate bonds, than when investing in safe' government bonds. The gap (or spread') between the rate paid on a corporate bond and a government bond will get bigger, the riskier the company.

So a junk' bond with a low credit rating would pay more than an investment-grade' corporate bond with a decent credit rating. This in turn would usually pay more than a US Treasury or UK gilt.

The argument now is that bond investors should move from taking maturity risk to taking more credit risk. In other words, rather than investing in safe' government bonds, they should go for the riskier stuff that offers a higher interest rate.

Now there's a certain logic to all this. You see, if interest rates are rising, it must be because the economy is on the mend. And if the economy is on the mend, then companies are less likely to go bust. And if companies are less likely to go bust, then that means investors will stop asking for as much extra interest. In other words, the spread' will shrink.

Trouble is, that might make sense if we'd seen a huge number of companies go bust over the past few years, as you'd have expected in a recession. However, that's not been the case. The default rate on junk bonds is currently very low, at below 3%.

The fact is, the Fed's artificially low interest rates have helped prevent the sort of carnage you would normally have expected among junk bonds. Other than a bad year in 2009, junk bond defaults have been surprisingly low.

Indeed, as investors have been forced to desperately seek income by the Fed, demand has surged. Borrowers have been able to negotiate more favourable deals. "Covenant-lite" loans which have less demanding terms accounted for more than half of all loan issuance in August, reports the FT. That would be the second-highest ever, after January this year.

This hardly smacks of an undervalued, bargain asset class. Rising interest rates will put pressure on everyone from indebted consumers to over-indebted companies. So if interest rates normalise', I suspect we'll see default rates start to do the same.

If you're looking for beaten-down bargains, I'd rather focus on cheap-looking stocks in emerging markets, or Europe, or Japan at least there's an argument that the risks are priced in with those markets.

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