A New World For Bond Investors

By Stephen D. Simpson, CFA | June 27, 2011 AAA
A New World For Bond Investors

The only constant in the investment world is change. This basic truth has spread even into the bond world - a corner of the market that has the undeserved reputation for being a bit sleepy and conservative. In just a few short years many basic assumptions that underpinned bond investing have gone up in smoke, leaving investors to figure out what the new normal truly will be. (To get you started on the basics of bonds, check out 5 Basic Things To Know About Bonds.)

TUTORIAL: Bond Basics

Sovereign Default - Not Just a Third World Phenomenon
Defaults on sovereign debt are hardly new; Africa and South America have struggled with them for years and they have long been part of the backdrop of emerging market bond investing. What is new, though, is the risk of these defaults spreading into the developed world and shaking up some of the fundamental assumptions about risk in bond investing.

Although there hasn't actually been a sovereign default in Europe yet (Iceland never defaulted on sovereign debt, and Greece and Ireland haven't yet), many investors feel it is only a matter of time. Even allowing for the reality that countries like Greece, Ireland and Spain were never thought to be as financially strong as Germany or Sweden, this is a fairly shocking turn of events. While the Eurozone will likely stay intact throughout this mess, it has clearly shaken investors and should lead them to revisit their basic assumptions about risk in that region.

Even more shocking is that discussion of default in the United States has moved beyond the paranoid fringe and into the mainstream. Some of this is due to mostly technical matters (like the statutory debt limit) and not an inability to refinance debt - the United States still enjoys very low interest rates and plenty of demand for Treasuries. That said, investors are finally beginning to look at the budget deficits and debt burdens as unsustainable. For a country that has long lectured the rest of the world about getting its financial house in order, this is quite a change and it raises the specter of higher rates in the future for the United States. <(For more on what effect the national debt has on the general population, read What The National Debt Means To You.)

Mortgage Bonds - Apparently Housing Prices CAN Decline
Any thoughts that the Japanese real estate bubble was somehow a unique instance of delusional valuation and feckless lending has been torn asunder by the United States housing bubble. It is remarkable in retrospect, but a huge number of otherwise smart people actually did believe that housing prices could never decline by double-digit amounts in the United States, and certainly couldn't do so for any significant stretch of time.

With that sort of hubris in place and a system of banking regulators that saw no reason to actually do their jobs despite ridiculous loan products like "pick a payment" spreading through the system, the fuse was lit on the mortgage-backed bond market. Even more troubling were the absurd practices in mortgage bond underwriting - slicing and dicing even the most toxic garbage into instruments that could be dutifully stamped as "AAA" by the respective ratings agencies.

Now it is an entirely new world for mortgage bond investors. People now accept that housing can get very ugly and stay that way for a while, to say nothing of realizing that there is more to due diligence than simply looking up the rating on a bond. Nobody knows what will ultimately happen to Fannie Mae and Freddie Mac and whether the government will continue to effectively underwrite housing lending in the United States.

What does seem clear, though, is that the supply of new mortgage bonds is likely to be low for some time and it will be many years before former investors in these instruments will go near them again. Oddly enough, that may make them a good option for risk-tolerant investors - after all, it often makes sense to own what others irrationally hate. (For those still unaware of the risks involved with investing in mortgage backed securities, see The Risks Of Mortgage-Backed Securities.)

Black Clouds over Munis?
While Meredith Whitney's hyperbolic predictions of doom and gloom across the muni market are very unlikely to come to pass, this market has undergone its own shake-up. Munis are supposed to be sleepy and safe, but investors found that they can ultimately hold many of the same risks as other kinds of debt. Many municipalities gorged on cheap debt and did so with inflated expectations of property tax receipts and ongoing economic growth. With the recession slamming housing values and personal income, many municipalities have faced increasingly tough budget choices and increasingly nervous bondholders.

Making matters worse, confusion over the tax treatment of Build America Bonds and discussion of altering the tax treatment of munis in general has led to periodic panics across the market. With favorable tax treatment a cornerstone of municipal bond investing, both investors and issuers have had to deal with unfamiliar uncertainty and the possibility of a new set of rules. (To learn more about Build America Bonds, see Build America Bonds: Should You Buy?)

A New World with New Risks
Bond investors have always had to wrestle with risks like default, inflation, deal flow and reinvestment. What is different now, though, is the scale and location of those risks. Default risk is now a developed world problem, and the United States is facing relatively rare concerns about its fiscal sustainability and inflation.

On top of that, investors have had to realize once again that history has only limited predictive value and that complacency is the biggest risk of all. Astute investors who remained willing to challenge conventional wisdom, reexamine assumptions and rely on their own due diligence came through the credit crunch and recession in fine shape - and that will likely always be the case. However new the bond investor's world may seem today, good due diligence and independent analysis has always been a good recipe for handling new risks. (Bond are still a good investment choice for many, for more read Bonds: They're Not Just For Seniors.)

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