My F&M

Bond Spreads

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For some time we have cautioned that investors were not being adequately compensated for taking on incremental risk in their bond portfolios and we have been gradually upgrading the quality of bonds purchased in portfolios.  

The extended period of low interest rates, however, has exacerbated this situation. In addition to the heated demand for junk bonds, we have been seeing increased issuance of leveraged loans and “covenant lite” loans where lenders have omitted language in bond documents that would restrict the financial activities of the borrowers and protect investors. This kind of activity is reminiscent of the imprudent behavior exhibited by investors in 2007 and early 2008. The chart below shows the dramatic decline in risk premiums as measured by quality spreads (the increased income available from buying riskier high-yield bonds rather than US Treasury bonds).  

This is not just an academic exercise. If spreads just returned to the levels of 2003 (let alone 2009), the value of these bonds would drop by 25% without any change in interest rates!  

The yellow caution light is flashing. Consequently, we have recently accelerated our process of upgrading bond quality in portfolios. In the near future, we may rebalance existing positions by swapping some lower rated bonds into higher quality bonds.  While this will temporarily reduce interest income, it will protect principle when the inevitable cyclical widening of spreads occurs.  As in other areas of investing, we have to be disciplined with fixed income and take higher risks only when the market offers high enough rewards to compensate us for those risks.