Many people have been thinking a lot about interest rates over the past several years. When rates fell to multi-decade lows, it was paradise for borrowers seeking low-cost financing on mortgages and other loans, but savers had a tough time generating the income they counted on to pay their living expenses. Later, as rates started to rise again, those same borrowers started getting pinched, especially those who failed to lock in those low rates with fixed loans. In addition, the current inverted shape of the yield curve has many economists convinced that an economic recession is right around the corner.
One element of the bond market that has largely gone unnoticed, however, is the difference in interest rates between high-quality conservative bonds and lower-quality corporate bonds. While investors have traditionally been able to enhance their yields by taking on riskier bonds in their portfolios, the current interest rate environment has taken away much of the incentive to buy lower-quality bonds. This unusual condition has many implications for the bond market specifically and for the economy in general.
Interest rates and bond spreads
As with most investments, bond yields vary depending on the perceived risk involved with particular bonds. Treasury bonds are commonly seen as the safest type of bonds because they are backed by the full faith and credit of the U.S. government; there's no reason why the government would ever default on these bonds, since they can always simply print more money to use to repay them when they mature. However, corporate bonds that businesses issue in order to raise capital always have some level of default risk associated with them. In the worst case, if a company goes out of business, then bondholders may not be able to recover the full amount that they invested.
In general, the greater the chance that an issuer will default on its bonds, the greater the interest rate that investors demand in order to assume the default risk. Companies like Moody's (NYSE:MCO) and Standard & Poor's do detailed analysis of bond issuers and assign each issuer a rating based on the chance of default and other risk factors. The ratings facilitate comparisons among various bond issuers. For each rating category, you can gauge how much extra return bond investors receive by comparing the yields on bonds in that category with the yields on Treasury bonds of the same maturity. The difference between these two rates is called the spread.
Lower rewards for greater risk
In the past several years, spreads between high-quality and low-quality bonds have dropped sharply. According to data from the Federal Reserve, people investing in BBB-rated corporate bonds, which are the lowest-quality bonds that are still considered investment-grade bonds rather than high-yield junk bonds, are currently earning about 1.5% more in yield than those who buy similar Treasury securities. While this may seem like a reasonable premium, the spread was more than twice as large as recently as just four years ago. Even junk bond spreads have compressed significantly as bond investors search for any way possible to increase their yields.
The problem with investing in bonds with higher risk is that even relatively infrequent defaults can eat away any extra return you earn from higher yields. For instance, if you own 100 different bonds, then each bond represents 1% of your total investment. If you're only getting paid an additional 1.5% to compensate you for the risk of default, then even if 98 of those 100 bonds never default, the two that do can end up costing you more than your profit margin.
Bad incentives for issuers
In addition to forcing investors to accept lower yields for their bonds, narrow bond spreads also tempt bond issuers to avoid the discipline necessary to obtain higher bond ratings. Just as individuals rely on their credit ratings for access to mortgages and other loans, companies rely on their bond ratings for access to bond market financing at the best rates. For example, companies that rely on the bond markets for capital inflows are extremely sensitive to rate movements, because the interest they have to pay on their debt has a big effect on their bottom line each quarter. If bond spreads are wide, then companies have a big incentive to take steps to improve their ratings, such as reducing their overall debt levels and improving their cash flow levels.
However, if spreads are narrow, then issuers don't have to pay a lot more in interest even if they have a relatively low rating. This can cause issuers to borrow more than they can afford or to act less responsibly in evaluating business strategies. When companies take on risky projects in response to narrow bond spreads, they can find themselves with major financial problems if those projects fail.
Is the end coming?
Recently, there has been some evidence that at least some bond spreads may be starting to widen again. With the difficulties in the sub-prime mortgage lending market that have hurt companies like Novastar (NYSE:NFI) and New Century (NYSE:NEW), spreads on sub-prime mortgage securities have risen substantially. While this hasn't yet filtered into the overall bond market, it's one possible sign that bond spreads may reverse course in the future.
What this means for typical investors is that they're generally not getting adequate compensation to take on default risk by buying lower-quality bonds. Even though yields on Treasuries and other high-rated bonds are lower, the losses you avoid with them may more than make up for the lower yields. Conversely, investors and mutual funds that are buying lower-quality bonds may find that they would've been better off sticking with Treasuries in the long run.
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For more on the basics of bonds and how you can make them part of your investment portfolio, take a look at the Fool's Bond Center.
Fool contributor Dan Caplinger has mostly stuck with Treasuries and CDs for awhile now. He doesn't own shares of any of the companies mentioned in this article. Moody's is a Stock Advisor recommendation. The Fool's disclosure policy won't default on you.
