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.