The Risk Of Owning Bonds

The Fixed Income market has been a tough place to find much value for far longer than I can remember. And yet, that hasn’t stopped the returns from being nothing short of spectacular. In fact, it’s not hard to find securities that have outperformed equities, and most would agree that it’s been a surprisingly good year for stocks.

Easing Has Bid Up Prices
Take the iShares Investment Grade Bond ETF (LQD) for instance. Up 10.5% year-to-date, for high grade bonds debt. The current yield to maturity on the portfolio is 2.89% and a good part of the return for the year has come from price appreciation of the underlying bonds as the Fed’s relentless buying of government and mortgage debt has drawn investors to bid up the prices of other fixed income securities. If LQD returns 10.5 over the next year, 7.6% of that return will have to come from price gains which, given its effective duration of 7.8 means the yield to maturity will need to fall to under 2%.

The JPMorgan Emerging Market Bond Fund (EMB) has generated 14.5% so far this year, only 2% or so less than the S&P500. The yield on this portfolio has drifted down to 4.1%. For EMB to return 14.5% over the next 12 months, the same Math as in LQD means that, with an effective duration of 7.7 the yield to maturity will need to fall to 2.75%.

Pricey Closed-End Funds
Even more striking has been the performance in some of the closed end funds that invest in senior loans. We’ve liked the ING Prime Rate Trust (PPR) for quite some time, but evidently we’re not alone for it currently trades at a 4% premium to NAV. PPR has returned a staggering 28% so far this year as investors have piled into bank debt and high yield in general.

There’s never any easy money to be made, but none of these investments appears that compelling today. Earning the current yield would seem to be the best plausible outcome on LQD and EMB. This morning’s Employment report was also reasonably positive, with the Unemployment rate falling below 8% for the first time in over three years. We’ve owned these securities in our Fixed Income Strategy but recently exited. The risk/return just doesn’t appear attractive, though bonds have looked expensive for a long time with barely a pause in the march to ever lower yields.