Monday, June 23, 2014

Bond Spreads and What They Are Telling Us

The new world of investing is a different place with investors desperate for decent yields on Treasuries, CDs, GICs and bonds of all types that are above inflation. Thanks to Mr. Bernanke and now Ms. Yellen, yields on fixed income investments are at multi-generational lows and have remained there for several years.  The ZIRP (zero interest rate policy) has punished savers who, in the past, could rely on real (after inflation) interest rates that would provide a reasonable return on their investments, a return that would allow them to save a reasonable amount for their eventual retirement as shown on this graph:

As you can see, the real return on long-term inflation-indexed long bonds is around 1 percent but had been around or below 0.5 percent over the period from last half of 2011 to the middle of 2013.  In fact,  for a one year period from mid-2012 to mid-2013, the real yield was hovering around zero percent. That certainly is a disincentive to save, isn't it?

What this has done is drive investors, who may or may not normally be looking for an investment that involves risk, into buying investments that are riskier than they appear to be on the surface.  In particular, I am referring to corporate bonds.  As we know, yield on bonds is inverse to pricing on bonds; as the price rises, the yield drops and vice versa.  As well, as demand for any bond rises, the price also rises (the old supply and demand curves come into play), pushing down yields.

Because corporate bonds are often deemed to be riskier than sovereign bonds like Treasuries, they trade at a premium.  For example, the risk of default on a Treasury is perceived to be approximately zero (a concept that I have trouble with given the frightening growth rate of the debt) whereas the default risk on corporate bonds varies with the creditworthiness of the issuer.  Various institutions like Standard & Poors and Moody's rate bonds based on the aforementioned creditworthiness and assign a letter rating as such:

Please keep in mind that, by definition, a junk bond, high-yield or non-investment grade bond has a rating of BB or lower. 

Obviously, a bond rated AAA will be preferred by investors when compared to a bond rated CCC since the chance of defaulting on a triple A bond is essentially zero (i.e. it is risk free) when compared to a bond rated triple C (i.e. it is riskier).  To make up for the difference in risk, bonds are priced accordingly which is reflected in the yield.  For example, the price of a triple A bond will be higher that the price of a triple C bond, resulting in a lower yield on the triple A bond and a higher yield on the triple C bond.  This spread, when the option of the bond issuer to cash in early is included, is known as the option-adjusted spread or OAS and is defined as:

"A measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst would use the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond...The OAS takes into account two types of volatility facing fixed-income investments with embedded options: changing interest rates (which affect all bonds) and prepayment risk."

Now, let's get to the meat of this posting.  Here is a graph showing what has happened to the OAS of BBB bonds (the issuer has adequate capacity to meet its financial commitments but is more subject to poor economic conditions) since the beginning of 2009:

By definition, these are not considered junk bonds.  Notice that when the merde hit the fan in 2009, the spread between a risk-free bond and a BBB bond rose to nearly 8 percent?  That's because investors had some concerns that BBB-rated bond issuers would not be able to pay back their debts so they demanded a very large premium for taking the investment risk.  As time has moved along, this premium dropped and currently stands at only 1.45 percent, a five year low.  That's largely because the demand for these BBB rated bonds has risen, pushing the price up and the yield down, largely based on the higher than normal demand from desperate yield-seeking investors.

For comparison's sake, here is a graph showing what has happened to the spread for CCC bonds, keeping in mind that, by definition, CCC bond issuers are currently vulnerable and are dependent on favourable financial and economic conditions and are considered by the ratings agencies to be junk bonds:

The spread on CCC bonds hit a peak of just over 36 percent in early 2009 because the issuers ability to repay their debt was considered to be very low.  Again, as time moved along, the spread dropped to its current level of 6.41 percent, again, a five year low as in the case of the BBB-rated bonds.  As I noted above, the spread on these bonds has dropped partially because of high demand from desperate investors.  Essentially, even though the risk is high on these junk bonds, investors are only demanding a modest interest premium that doesn't really reflect the risk involved.

Basically, today's corporate bond market has almost completely priced out risk.  Mr. Bernanke's ZIRP has allowed less than creditworthy borrowers to borrow trillions of dollars at ultra-low interest rates, setting us up for fun and games when interest rates rise.   Investors are so desperate for a decent return on their investments that they are ignoring the risk component of lower rated junk bonds.  Given that the economy has performed rather poorly since the so-called end of the Great Recession, the risks involved in a junk bond investment are far higher than they have been in many years.  If the economy should take a turn for the even worse, bondholders with a portfolio of what could well be "junk bonds" could be in for a world of pain.  On the upside, however, as usual, the big winners are the Wall Street investment banks underwriting these bonds, particularly given that they issued $462 billion worth of these potential toxic products in 2013 alone.


  1. Regardless of what you name it the "Federal Reserve Nightmare" or the "Yellen conundrum", the box Ben Bernanke made when he painted both himself and the Federal Reserve in a corner remains. Bernanke has by passing the chairmanship to Yellen escaped from the QE trap but left the rest of us fully in its grasp.

    With a policy of loose and cheap money and an inflation target of just 2% the Federal Reserve continues to please those gambling that not fighting the Fed guarantees profits. As many Americans are forced to pay higher food, gasoline, and health insurance premiums, I wish someone would let the Fed know we are already there. Any thought that inflation is not higher has come from the false illusion brought from lower payments on things like auto loans and mortgages, this is a one off and will not continue. More on this subject in the article below.

  2. It seems part of the problem is how the Fed and others measure inflation. Magically, it seems, the inflation seems within the target range lately.

    If a true measure of inflation were used, we may not be in the endless cycle if zero interest rates. I once read an article that suggested the Fed should take stock (and bond?) prices into account when measuring inflation.

    A novel suggestion, but i'm convinced this 'zero interest policy forever' is a wealth transfer scheme that no one knows how to put to end in a controled fashion.