Balloon, boom or boomlet — bonds deserve consideration

October 12, 2009
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The credit crisis appears to be waning, calls that the recession has ended are rising in frequency, and the stock market has enjoyed a double-digit run to date this year. Fall often can be a difficult time for the market, as many of us were reminded last year to an extent unknown in our lifetimes.

Think about the many “B” words employed to describe various market conditions: bulls, bears, boom, bust, bubble, burst — all of which are used much more prolifically now than one year ago. And where once pundits might have labeled the conditions that led to our most recent economic crisis something like “recessiongate” — in reference to the confluence of factors that created the crisis — now the more likely description includes the term “bubble.”

As it relates to the current situation, the warning being conveyed now contains a double “B” term: bond boom.

A recent New York Times article cited not only the stock market’s rally, but a quieter one that has taken place in the corporate bond market. The bond market rally — which was triggered by the need for businesses to pay larger premiums to raise money from investors — first attracted notice early last summer. As the rally has continued to gain momentum, investors have indicated a corresponding willingness to pay higher prices for corporate bonds.

In the year’s first half, when anything greater than a low, single-digit return provided a welcome diversion from dismal returns, corporate bonds were identified by Norris, Perné & French as an opportunity. That opportunity, however, was and is pursued with an emphasis on underlying quality of the bonds acquired.

The most recent bond surge on a national basis has investors plunging into the markets ranging from the highest quality triple-A securities to junk notes. Discernment doesn’t carry much weight among investors who have fled the relative safety (and low returns) of money market funds and treasuries into bonds and bond funds.

Correspondingly, bond Exchange Traded Funds also have enjoyed the surge, but are starting to show some slowing based on the differences between ETF share prices and the value of their underlying holdings. In some cases, the funds have dipped below their benchmarks, failing to return to investors expected returns.

But if it’s any mark of the investors interest in bond ETFs, more than half the new cash invested into ETFs in 2009 were directed toward the bond categories — this despite the fact that the index drift away from the benchmarks seems to be a growing challenge.

For the corporate bond market, another challenge has risen: As the market has soared, the spreads (yield difference between corporate bonds and U.S. Treasury securities) have shrunk — from 16 percent at the beginning of 2009 to 7.5 percent this month. And as the demand has grown, investors are more frequently asking themselves: Is this a boom or a bubble, and when will it end?

It’s hard to make a case that we’re seeing a bond bubble. While the spreads are shrinking, it’s more likely than not a response to the dislocation of the financial markets in 2008. The spreads still are relatively wide compared to historic standards, so what we’re seeing is more likely a normalization than an end to a boom or a bursting of a bubble.

Corporations are beginning to raise money again in ways that have not been available over the past few years. These signs that there may be a slowing in corporate bonds offerings are starting to show themselves, primarily in the form of the return of mergers and acquisitions and the rise of initial public offerings.

Boom or bubble, bust or burst, bonds will continue to provide an attractive opportunity for income. Investors are better served investing in individual bonds rather than funds, depending on their access to bond offerings and a well-placed strategy that addresses individual income needs, time horizons and tax situations.

Bonds will continue to provide investors with an opportunity to reduce portfolio risks, provided that investors focus on the inherent quality of the bonds prior to purchase.  Some would argue that bond funds provide more shelter from volatility than individually held bonds, but the latter offers the chance to control the portfolio and meet benchmarks, while we have seen in recent months the difficulty bond fund managers have had in meeting their benchmarks.

What are the potential downsides to bonds? Those would be seen in one of two opposite economic situations: a rapid worsening in the economy or, conversely, a quick recovery. Neither appears likely, but in the former situation, bond issuers (companies and government entities) could have a difficult time paying off debts, thus depressing their bonds’ prices. In the case of a rapid economic recovery, bonds could underperform the stock market, making bonds a far less attractive investment.

With the nation’s economic prognosis of little or no growth in the near-term, there remains little likelihood of either situation. The greatest challenge for those who wish to reduce risk in their portfolio, while potentially picking up a few percentage points of interest over more conservative investments, will remain the availability of the highest quality bonds.

Julie M. Ridenour is director of business development for Norris, Perné & French, LLP. 

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