“New highs” have different meanings for the stock and bond markets. New highs in equities are cheered universally, with big numbers such as Dow 30,000 celebrated by investors sitting on presumably big gains. For bonds, new highs in prices translate into new lows in yields, given that the two quantities move inversely.
On the latter score, corporate bond yields are hovering near or at historic lows, which is arguably more important to fixed-income investors than an uptick in the benchmark 10-year Treasury note yield back to the recent high of all of 0.95%. The yield on the Bloomberg Barclays U.S. Corporate Index this past week was 1.84%, just above the 52-week (and all-time) low of 1.8%. For BBB-rated corporates at the low end of the investment-grade scale, the yield was just 2.12%, a bit over the low of 2.09%. And in what ought to be a violation of truth in labeling, the ICE BofA High Yield Constrained Index was at a record low of 4.616%.
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Those numbers prompted a call to Dan Fuss, the ageless manager of the Loomis Sayles Bond Fund (ticker: LSBRX), to see how he’s coping. “Not well,” he replied only a bit facetiously. In the old days, he recalled that he could tell clients how good things were after a rally, which he quipped basically amounted to “same bonds, new prices.”
By contrast, Fuss and every other bond manager has to confront the problem that reinvestment returns have plummeted. In other words, compounding of interest can’t work its magic to grow assets to meet the future needs of institutions such as pension funds and endowments. “Toss in an extra prayer for life insurance companies, which have long-term obligations” to policyholders, he says. It isn’t a unique observation, but one that people have been wrestling with even before this year’s events.
Investors aren’t compensated for the risk they assume, Fuss continues. Spreads—the extra yield for riskier securities—are slim in the corporate market. That’s true in spreads between BB- and B-rated bonds (the upper and mid-tiers of the high-yield market) or between BB+ and BBB- (the dividing line between high-yield and investment-grade bonds).
“I assert, currently, you are not getting paid for credit risk and this is certainly a major consideration when you look at your portfolios,” Mark Grant, chief global strategist, fixed income, at B. Riley Financial, similarly writes in his Out of the Box client note. This bond-market veteran puts the blame on the Federal Reserve and other central banks for creating a “borrower’s paradise” and “fixed-income investor’s hell” by holding interest rates down, in part to help finance massive fiscal deficits.
Part of the explanation for the lack of compensation for credit risk is also the proliferation of passive funds, notably exchange-traded funds, Fuss continues. As an active manager, he admits this is a bit self-serving, but it results in the specific risk of bonds being “underevaluated.” There also is the pressure to put money to work in the market, with over $335 billion flooding into bond funds this year through Nov. 24.
With yields so low, the risk is that they’ll rise, which means bond prices risk falling. Based on a five-year forecast, Fuss thinks it reasonable that interest rates will be higher than currently. Corporations are acting on that expectation, issuing bonds now in anticipation of paying off current issues as soon as they can be called, he notes.
For investors, however, he doesn’t see the payoff for taking those risks. “The counterargument is, you’ll be good for about two years, going out on the [yield] curve and taking credit risk. Would you get on a plane with those odds?” he asks rhetorically.
Fuss admits that he gets unsolicited input from shareholders in the $9.1 billion Loomis Sayles Bond fund, notably about maintaining the dividend, which yielded 2.68% as of Nov. 30. To that end, the fund has a relatively expansive field of investments it can play in. The equity securities limit is up to 20%, from 10% previously, while 35% can go to below-investment-grade debt.