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A Fed-Induced Bond Bubble - The Fixed Income Dilemma

Corporate BondsJuly 30, 2014 | Posted by Steve McCurdy

Bonds Defined

Let me start off by saying I don't like bonds in this environment. A bond is a contract between a borrower and a lender, generally with a specified interest rate, some form of periodic income (the “coupon”), and a date by which the contract matures. In a normal, unregulated economy, a bond’s interest rate is determined by several factors, the most important of which is the quality of the underlying bond issuer. When they are issued bonds are rated (“AAA, BB, etc,”) by independent agencies. The rating agencies analyze the financial statements of the issuer to determine the risks of default, and they also consider the value of the bond collateral if the bond issue is secured. The rules are simple; the higher the bond rating, the lower the interest rate. So, in a real economy, a zero interest rate bond would imply that a bond is risk-free.


Interest Rates & Yield

Bond market prices (values) are directly influenced by prevailing interest rates. Market prices and interest rates are inversely correlated, so sharp rises in prevailing interest rates have devastating effects on bond prices. Understandably, therefore, the laser-like focus of bondholders is and should be on prevailing market interest rates. But although rates represent a huge risk for the bond market, they are not the only risk. In normal times investors also pay close attention to the issuer’s credit and solvency. 
The total world bond market is estimated at $150 trillion, and an abnormally large portion of these bonds have been issued recently with Central Bank-induced interest rates at virtually zero. The absence of income causes fixed income investors to scour the world to find higher-yield issues, and this preoccupation with yield sometimes causes them to overlook credit and liquidity risks. These risks remain very real, and occasionally rear their ugly heads. The recent financial crisis in Puerto Rico, for example, caused prices for Puerto Rican bonds to drop from the 80s to the 30s in two weeks, wiping out the holders of these bonds. 

Rates and Risks

By keeping the coupon rate at or near zero, the world’s Central Bankers are saying in essenceUS Savings Bonds that every bond issuer and every new bond issue are now without any solvency risk. Astute market observers know that the truth is just the opposite. Sovereign governments of every size on every continent are at or near insolvency. In a free and unregulated market investors would not touch these bonds at any interest rate, but today’s market is neither free nor unregulated.
Central planners possess formidable interest rate tools as well as a powerful public relations apparatus, and in the sovereign segment of the bond market, they are sometimes both issuer and the buyer of the same treasury bills. They know full well that the slightest hint of an upward rate move A Coupon Bondwill send investors heading for the exits, and they will continue to use all their tools to keep rates at near zero.


So even though popular consensus has long been that a general rise in interest rates would set the inevitable collapse of the bond market in motion, maybe it won’t. Perhaps instead, positive investor psychology will begin to erode and the Minsky Moment will be an awakening and a growing realization that the world’s outstanding sovereign debt, country by country, can simply never be repaid. Greece and Puerto Rico were shots across the bow, and we believe that very soon the truth will out. I don't own any bonds in this low interest rate environment, and I like the way that Doug Casey describes bonds, particularly low interest rate treasury bills. He says that they provide the holder with "return-free risk."  

Learn more about the impending bond crisis here and here.

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