There were a confluence of factors that got me to thinking about the bond market this week.

The first was some reading I came across on the credit quality of the investment grade corporate bond market. A low interest rate environment for a number of years has distorted the historical makeup of the corporate debt market with many companies teetering just above the lowest rung on the investment grade ladder.

The other was discussing with a friend, options for managing his parent’s retirement portfolio. These parents just saved as they were told to do, likely through and IRA which they invested in mutual funds and they expect their son who works in finance, to manage for them into their golden years. It made me realize that I often am so focused on equity funds and touting the benefits of keeping it simple with ETF’s and index funds, that I often neglect to discuss the bond market in more detail.

So first I will discuss the risks I see in the current bond market given the interest rate outlook in the US and then how investing in bonds and bond funds can make up an important part of your portfolio, especially if you are at retirement age or already retired.

The Dangers Lurking in Bonds

I really hate headlines like these, it’s one reason they call economics the dismal science, everyone always seems to be worried about some impending doom that is ever imminent.

To be clear, noting the risks in the current market doesn’t necessarily mean that it is going to blow up and I am ringing the alarm. If I knew exactly what was going to happen I wouldn’t be writing this blog, I would have quit my job to create my own hedge fund to profit from what I knew was certain to happen.

Rather, it is worth evaluating the risk of investments and particular markets, not to run away from them, but make informed decisions for myself and other people on how much of their portfolio to allocate towards these investments.

• First Risk – The Credit Quality

I was quite alarmed earlier in the year to learn that due to companies loading up on debt, the composition of the investment grade corporate bond market was now 50% BBB or BBB- rated, the two lowest ratings on the investment grade scale.

When we think investment grade, we often think of bonds from blue chip firms like Johnson & Johnson or Proctor & Gamble whose ratings are in the AAA and AA range.

Bonds can be used for expansions, R&D or anything else that can improve a company’s bottom line. They can also be used for leverage, which juices returns for shareholders, which is why so many CEO’s, when the economy is good and rates are low, issue piles of debt to boost their share performance for stockholders.

If you are a CEO and don’t have a good project generating your hurdle return, you can still issue debt and just use it to buy back your own company shares. This works like a shadow dividend because it reduces the number of shares outstanding, so even if profits are flat next year, the profits per share will increase. It’s also easier to cut than a dividend. Usually dividend cuts send US investors fleeing. A dividend cut is immediate and explicit, stopping share buybacks is less distributive psychologically for many investors because they don’t see the results immediately.

Returning wealth to shareholders through buybacks has become very popular in the last 2 cycles for large corporates. Although buybacks dipped in the first quarter, they still remain near an all time high for the S&P 500.

Source: PR Newswire

Moody’s estimates that in a downturn, 10% of BBB- rated bonds will be downgraded to junk. When they are such a high portion of the investment grade (IG) market though, would contagion make BBB- bonds the new toxic asset class as fund managers try to offload them? We are already sitting at what looks like the cyclical peak for corporate bond issuance compared with the last 2 cycles (see below). If fund managers try to offload a significant portion of their BBB- bonds at once in an attempt to pare losses, they could end up making the situation worse by plunging prices even further, which would then impact their entire IG portfolio. This brings me to the next risk.

Source: Market Watch

• Second Risk – Liquidity

I cautioned my friend managing his parent’s portfolio that yes, I still like ETF’s even for bond funds but this is the one area where I would also consider mutual funds for a very specific reason and that is liquidity.

Equities are very liquid, easily traded and there is almost always a buyer. Bonds are different, they are much less liquid, they mature, some default etc. ETF’s for bond funds have a problem similar to that of banks: they have illiquid assets they are holding, but depositors, or in this case investors, can take their money out any time. Let’s say a bond ETF see’s a massive outflow of investors at once, given the illiquidity of bonds, a manager could not likely offload a significant portion of the portfolio so quickly unless they were to sell them at fire sale prices, which would further drop the value of the fund and probably spur more investors to sell, creating a vicious cycle.

In addition, due to regulatory changes, primary dealers, which were usually banks in the past, are not likely to step in to fill the gap should large bond ETF funds have to sell their holdings.

Source: Bloomberg

• Third Risk: A Different Type IG Interest Rate Risk

Even in bond mutual funds, you don’t always get the advantage of holding a bond to maturity despite the price variations, which could impact returns. If you have a long duration bond fund which is supposed to hold only those bonds which have 10 years or more to maturity, then as soon as a bond has 9 years to maturity it is sold off. If the price for that bond dropped before it was sold off a loss is realized rather than if an investor just held the bond to maturity. Due to this risk, it also makes sense to do some laddering: holding various parts of the yield curve, which would include short, medium and long term funds. This can help capture changes in the yield curve, which currently is inverted.

What Is Grandpa to Do?

Given the low rate environment we are in, the current bond funds are offering what I consider to be lackluster yields when compared on a historical basis. The problem isn’t just a US problem either. Much of the rich world is either already experiencing negative real rates or negative nominal rates as well.

The leverage effect that debt gives to companies bottom line and the low returns on bonds now seemed to have flipped much of the traditional bond/equity mix advice at retirement.

When bond yields were higher in the early 2000’s I often saw much advice of a 60/40 bonds to equities portfolio for those approaching retirement. When I checked it out recently though, I was surprised to see suggested portfolios much more heavily weighted towards equities even though these asset mixes were considered “conservative” or “moderate”. Take a look at the suggested proportion of equity for the portfolios of those in their 60’s, 70’s and above 80 by Charles Schwab.

I was surprised to see so much geared towards equity for someone in their 60’s but if people are living into their 90’s you have to think this portfolio may have to last another 30 or so years, so more equity makes sense, and bond funds paying 3% are just not going to get the job done for many people.

Conclusion and Recommendation

Each situation is unique if you are on the verge of retirement and looking at how to construct your portfolio. The fact of the matter is that longer lives and low rates have cornered many into weighting heavily into equities, even as they retire. So no the bond market is not about to blow up your retirement portfolio but it seems a blow up in the equity market could still be a risk for those just approaching retirement.

When it comes to fixed income for those in their 70’s and 80’s, diversifying with ETF’s, mutual funds, holding actual bonds will be your best bet to hedge against a number of different scenarios that could affect the bond market, be it a deterioration in credit quality, liquidity or even a surprise in higher inflation. This is one area where just piling into ETF’s could add some risk which your portfolio doesn’t need.

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