Bond Bubble Double Trouble

Standard textbook financial theory says that bonds are less risky than stocks. The basic reasoning is that bonds have priority in the overall corporate pecking order.

If a company stops paying dividends on its stock, shareholders generally have no choice but to suck it up. But if that same company stops making its bond payments, the bondholders have far more recourse -- even up to taking control of the entire company.

When textbook logic breaks
That makes sense, and purely from the perspective of cash flow reliability from bond offering to maturity, those textbooks are absolutely correct. The problem is that bonds can still be risky investments. And when market conditions are just right (or is that "just wrong"?), the risk can be substantial, indeed.

First and foremost, bonds are exposed to interest rate risks. The higher interest rates go, the less existing bonds with fixed coupon payments are worth. The longer the remaining term and the lower the bond's coupon rate, the bigger the impact of interest rates.

Additionally, bonds are exposed to credit quality risks. If the market or a ratings agency determines that the company that issued the bond is riskier than originally believed, a bond's price can drop as new investors demand higher future returns.

If both happen at the same time -- overall rates go up as a company's credit quality deteriorates -- that spells double trouble for bondholders. Investors can see the current value of their existing bonds deteriorate from both factors, and the result won't be pretty.

What can happen?
Individual bond prices move in response to interest rate changes based on something known as "modified duration." The bigger a bond's modified duration, the further the bond will fall if rates for that company's debt rise through general market pressures, rating downgrades, or both. While interest rate changes don't affect an existing fixed-rate bond's cash flows, that's not much comfort for any investor who may be interested in selling a low-coupon bond anytime before it matures.

The chart below shows recent rates and moves in the corporate bond market. Notice how for all time frames cases, the lower-rated (though still investment grade) "A" bond has higher interest rates than the better-rated "AA" bond. Note, too, that the longer the time frame, the higher the interest rates, which usually means the market is pricing in more risk and/or longer-term inflation with those longer term investments:

Source: Yahoo! Finance as of Jan. 23.

Remember, too, that the longer the time until maturity, the bigger the impact an interest rate change has on the market value of an existing bond. That makes the 0.65% swing in the 20-year AA bonds in a month all the more scary. If that's a sign of the future direction of the bond market, existing bondholders are at risk of losing quite a lot of current market value as rates rise.

Who's most at risk?
On their own, either generally rising interest rates or debt rating downgrades can be painful for owners of existing bonds. But when you put the two together, the impact is magnified. The companies in the table below have all recently either seen or been put on notice that their ratings would be reduced. Their existing bonds have suffered, and any future borrowing they do will be more expensive as a result, unless they improve their balance sheets and operations:

Unlike stocks, where the market may dramatically move a company's share price daily, bonds are priced based almost entirely on the reliability and predictability of their cash flows. Large shifts in bond prices are usually due to either overall swings in market sentiment or fundamental risk changes in the underlying companies' abilities to pay back their debts.

When the likelihood of generally higher rates meets a deteriorating credit rating, the combination spells double trouble for bonds and their owners.