Investment Insight | Bonds are a bubble waiting to pop
What a difference a year makes. In early March 2020 investment markets were panicking at the prospect of the COVID-19 virus going global. This saw share markets drop rapidly and credit spreads (the additional price corporates pay to borrow money) increase sharply.
Fast forward twelve months and both share markets and corporate bond prices are higher than before the pandemic. Some commentators are concerned that share market valuations are high, but in many respects the true bubble is in the corporate bond area.
Respected investor Warren Buffet recently warned in his annual letter to Berkshire Hathaway shareholders that “Fixed-income investors ... face a bleak future” and that bonds are not the place to be these days. Why did he say this and why do we agree?
Looking at a number of measures, bonds look to be sitting in extreme territory.
Valuations high vs history
Credit spreads are now tighter than they were prior to the start of the pandemic. Investment grade bonds spread in the United States are at 13-year lows.
Record low yields
Interest rates around the world have fallen dramatically over the last year. In turn, the yields offered by corporate bonds have fallen to record low levels. Bond investors are receiving less return on their investments than ever before and this means that they have almost no cushion if markets become volatile or if there is an inflation shock.
In fact, there does not even need to be an inflation shock as in many instances the yield available is below the level of expected inflation. This means that bond investors are going backwards after the impact of inflation is taken into account. Across the United States investment-grade bond universe, 40% of bonds by value have a real yield (after inflation) of -0.50%.
Record term to maturity
Back in the early 2000’s the average corporate bond was issued for a period of approximately six years. As interest rates have fallen over time, the average term of the bonds has risen slowly, to the point that the average maturity term of the market is almost nine years.
This is important as the price of bonds becomes more volatile as the term to maturity increases. Moving from six to nine years increases the risk of a large price decline as interest rates increase.
Corporate balance sheets are becoming more leveraged
In general, the very large companies have used the opportunity presented by record low interest rates to borrow more. Initially the intention was to temporarily raise cash given the uncertainty presented by COVID- 19, but this borrowing is now likely to be permanent.
Borrowing costs, after inflation, are negative; in real terms, companies are being paid to borrow the money. As a result, they have little incentive to repay the loans and instead are likely to use the money to buy other businesses or undertake shareholder-friendly actions such as share buybacks.
Such an extreme environment says to us that the risk present in the traditionally ‘safer’ world of corporate bonds is now much higher than many investors realise.
Using our intelligent investment approach, we have positioned our portfolios to reflect the current investment environment. This includes increasing the levels of cash held in the Income Category and using derivatives to position all the investment categories so that they benefit as interest rates move higher.
Our actions mean NZ Funds KiwiSaver Income Category is up 8.93% (before tax and fees) year-to-date to 28 February 2021 versus the global and New Zealand corporate bond index which are both down -2.23% and -2.16% respectively. Our Managed Superannuation Service, Wealth Builder and Advised Portfolio Service Income portfolios have all performed similarly to this.
Fast forward twelve months and both share markets and corporate bond prices are higher than before the pandemic. Some commentators are concerned that share market valuations are high, but in many respects the true bubble is in the corporate bond area.
Respected investor Warren Buffet recently warned in his annual letter to Berkshire Hathaway shareholders that “Fixed-income investors ... face a bleak future” and that bonds are not the place to be these days. Why did he say this and why do we agree?
Looking at a number of measures, bonds look to be sitting in extreme territory.
Valuations high vs history
Credit spreads are now tighter than they were prior to the start of the pandemic. Investment grade bonds spread in the United States are at 13-year lows.
Record low yields
Interest rates around the world have fallen dramatically over the last year. In turn, the yields offered by corporate bonds have fallen to record low levels. Bond investors are receiving less return on their investments than ever before and this means that they have almost no cushion if markets become volatile or if there is an inflation shock.
In fact, there does not even need to be an inflation shock as in many instances the yield available is below the level of expected inflation. This means that bond investors are going backwards after the impact of inflation is taken into account. Across the United States investment-grade bond universe, 40% of bonds by value have a real yield (after inflation) of -0.50%.
Record term to maturity
Back in the early 2000’s the average corporate bond was issued for a period of approximately six years. As interest rates have fallen over time, the average term of the bonds has risen slowly, to the point that the average maturity term of the market is almost nine years.
This is important as the price of bonds becomes more volatile as the term to maturity increases. Moving from six to nine years increases the risk of a large price decline as interest rates increase.
Corporate balance sheets are becoming more leveraged
In general, the very large companies have used the opportunity presented by record low interest rates to borrow more. Initially the intention was to temporarily raise cash given the uncertainty presented by COVID- 19, but this borrowing is now likely to be permanent.
Borrowing costs, after inflation, are negative; in real terms, companies are being paid to borrow the money. As a result, they have little incentive to repay the loans and instead are likely to use the money to buy other businesses or undertake shareholder-friendly actions such as share buybacks.
Such an extreme environment says to us that the risk present in the traditionally ‘safer’ world of corporate bonds is now much higher than many investors realise.
Using our intelligent investment approach, we have positioned our portfolios to reflect the current investment environment. This includes increasing the levels of cash held in the Income Category and using derivatives to position all the investment categories so that they benefit as interest rates move higher.
Our actions mean NZ Funds KiwiSaver Income Category is up 8.93% (before tax and fees) year-to-date to 28 February 2021 versus the global and New Zealand corporate bond index which are both down -2.23% and -2.16% respectively. Our Managed Superannuation Service, Wealth Builder and Advised Portfolio Service Income portfolios have all performed similarly to this.
Source: Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Mark Brooks is Head of Income for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Mark's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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