Investors face dilemma on low bond risk premiums

By Al Yoon – Analysis

NEW YORK (BestGrowthStock) – A return to normality for U.S. credit markets and ultra-low benchmark interest rates are forcing bond fund managers to take on growing and potentially dangerous levels of risk in the search for decent yields.

Managers over the past year were well rewarded for taking credit risk as the economy rebounded from the financial crisis and the Federal Reserve left huge quantities of cash sloshing around in the banking system.

With spreads on the bond market — outside of the euro zone’s stricken periphery — returning to pre-crisis levels, funds are under growing pressure to find returns for households and businesses whose saving has helped rebalance the economy.

Buying longer-term bonds may not be smart given the belief that official interest rates will eventually rise and push prices generally lower. So going down in credit quality is the popular trade.

Managers are also nervous that they are accepting higher-risk bonds at levels that price in an overly rosy view of the recovery — similar to the bets that singed investors in the housing-driven collapse in 2007 and 2008.

“Clearly people are justifying investments they would have never considered 12 or nine months ago,” said Jason Brady, portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico.

“To what extent is it improved fundamentals, and to what extent is it ‘I have to buy something?’ It’s a lot of the second.”


Central banks’ main battle since the collapse of Lehman Brothers and Bear Stearns in 2008 has been to bring spreads back to within sight of benchmark interest rates.

Prices in almost all major bond markets have rallied as the crisis ebbed, government lending programs provided backstops for investors and the economy and housing markets began to turn.

On top-rated corporate bonds, yields are 1.60 percentage points above U.S. Treasuries, compared with 5.02 points a year ago. For riskier companies they are 5.68 points now, down from 14.46 points, and spreads on most asset-backed securities are 0.25 points versus 2.8 points.

Portfolio managers awash with cash will likely purchase more bonds and push yields lower yet, only increasing nerves.

Bond funds in 2010 have taken in $113.5 billion, compared with $38.2 billion for stocks, Investment Company Institute data show. Investors had pumped a record $32 billion into junk bond funds last year, according to LipperFMI.

“Hypothetically, a manager might not like their sector, but as a manager you are obligated to put that money to work,” said Robert Ostrowski, chief investment officer for Federated Investors’ taxable bond group in Pittsburgh.


The similarities the investing environment of the credit bubble are disturbing, analysts say. Reaching for yield in mortgage securities hasn’t encouraged looser residential lending like in the mid-2000s, but the demand in corporate securities is emboldening companies to offer investors less.

In home mortgage bonds, investors are getting higher yields by easing assumptions of loss from foreclosure. Investors who participated in the commercial mortgage bond rally have moved into securities with less protection, said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago.

The amount of money chasing distressed real estate assets is “staggering,” Barry Sternlicht, chief executive officer of Starwood Capital Group, said at a conference last week.

In a recent auction of failed bank assets, Sternlicht, a veteran real estate investor, thought the pool was worth 57 cents of face value but lost out to another who bid 81 cents. By compare, Sternlicht and other investors in October paid about 60 cents on the dollar for assets of failed Corus Bank.

“I remember this discussion of ‘what do you do in a yieldless world?’,” said Mitch Stapley, chief fixed-income officer at Fifth Third Asset Management in Grand Rapids, Michigan. “The rapidity of how fast we returned in this cycle is probably the scariest thing overall.”

The fiscal crisis in Greece points to the danger — that bond markets are headed for another shock that will spread along the yield curve and slow the global recovery.

Federal Reserve interest rates, meanwhile, have been at or below 1 percent for 19 months, rivaling the low rate policy run by former Chairman Alan Greenspan which many blamed for the housing bubble.

“We are sitting in a small asset bubble that has been created by low interest rates, and a substantial amount of liquidity in the system,” said Sadie Gurley, a managing director at Marathon Asset Management, a New York private equity and hedge fund firm. “Fundamentals aren’t that great, the economy is still fragile and we have people starting to do the same things they did three years ago to reach for yield.”

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(Additional reporting by Dena Aubin and Paritosh Bansal; editing by Patrick Graham)

Investors face dilemma on low bond risk premiums