One concept that arguably stands at the center of investing is this: The more risk an investor is willing to take, the more he or she stands to gain.
Plop your money into a bank savings account and your deposit will earn interest—but not much. That’s to be expected, because you can get your money back at any time, and in the unlikely event that your bank goes belly up, your savings account is insured by the federal government. In contrast, buy the corporate bonds of a distressed company in a lousy industry and you’ll receive a much more generous interest payment, given the uncertainty surrounding the company’s ability to pay off its debt. Or so you’d think.
These days, investors in the U.S. bond market, which happens to be the largest securities market in the world by a long shot, are not getting paid very much at all to take what could be perceived as a lot more risk. Put another way: The risk-equals-reward equation appears to be out of whack.
Professional bond managers are a little like race car drivers, measuring the differences in reward among various types of bonds just as a top-notch racing team measures lap times down to the hundredth of a second. But instead of measuring time, bond managers measure yield—the bond’s coupon rate of interest divided by the purchase price—down to a hundredth of a percentage point. In investing, that’s called a basis point; each percentage point is made up of 100 basis points. It’s like pennies on a dollar.
One of the most important distinguishing factors among different types of bonds is called “the spread.” And the most common spread measurement is the difference between the yield on U.S. Treasury bonds—which are viewed as having a very low risk of default because their issuer is the United States government—and the yield on various types of corporate bonds of the same maturity. (U.S. Treasuries are, like other bonds, subject to changes in market value based on changes in interest rates—that is, as interest rates go up or down from the rate at which the bond was issued, an investor selling that bond prior to maturity will be able to get less or more for it.)
Fritz Feuerherm, of AXA Investment Managers, is one of those professional bond managers warily watching the spreads in the bond market. “Go back five years, when we had a fair number of tech blowups and overleveraged situations; corporate bonds in October of 2002 were trading at 265 basis points over treasuries,” says Feuerherm, whose Minneapolis-based team manages more than $6 billion in bonds. “Today the average is 85 basis points.”
Because bond prices move in the opposite direction of yields, this means that corporate bonds of all quality levels appear pretty expensive and, at least on a historic level, aren’t compensating investors much for the risk they’re taking. So what’s going on here? Several things, according to Feuerherm.
››› An insatiable appetite for yield. The U.S. bond market offers some of the highest yields in the world—indeed, that’s one of the primary factors holding up the value of the U.S. dollar: Foreign investors buy dollars to buy U.S. bonds. Add to that the fact that many pension funds, pressed to buy bonds to fund their long-term liabilities to pensioners, are themselves bidding up bond prices.
››› The fundamentals of the bond market are relatively strong. Corporate profits are providing ample “coverage” for debt payments, cash flow is strong, and the amount of debt carried by companies is reasonable.
››› Bank lending has become more liberal. With loan growth slowing and fierce competition from other funding mechanisms, banks are willing to stretch their lending policies farther, Feuerherm notes, accepting more leverage and allowing more forgiving conditions tied to their loans. That makes loans more attractive for companies relative to bond issues.
But the ultimate question for investors is whether such things will leave a lasting mark on the investment landscape: Is the “risk premium” on various types of debt permanently lower?
Not as far as the fixed-income team at AXA is concerned. “Today, all three major central banks in the world—the U.S. Fed, the European Central Bank, and the central Bank of Japan—[are all] raising rates, trying to slow these economies,” Feuerherm says. “If you’re a corporation and you’re experiencing higher interest costs, what do you try to do? You try to raise prices. If you aren’t successful, your margins are going to decline, and investors recognize that there’s risk and say, ‘I want a higher spread, I want a higher risk premium.’ Something has to give.”
Meanwhile, Feuerherm and his colleagues have been steadily selling their lower-quality bonds in favor of higher-quality issues in more stable industries.
The lesson: Always be aware of the delicate balance between risk and reward. Sometimes good ol’ savings accounts may not be that bad a deal—relative to everything else.
