Financial advisers are at risk of getting caught in a classic “bond bear trap” — reaching for yield in a low-interest-rate environment, then getting hammered when rates ultimately rise. “We see this time and time again — when the Fed lowers rates, people go out very long [on the yield curve] and lower the bar on credit quality,” said Dave Pequet, president of MPI Investment Management Inc. in Hinsdale, Ill., which runs about $210 million in short-term bond money for high-net-worth investors. “When rates turn, they just get crushed. It’s a bear trap,” Mr. Pequet said. A yield curve similar to today’s took shape in 2003, when the Federal Reserve cut short-term rates to about 1%, he said. Then, investors who reached for yield, or locked in longer durations with bond ladders, missed out when short-term rates went to 5% in 2007. Now, with the one-year Treasury bill yielding 0.44%, short-term yields are even lower than in 2003, and the risks of interest rates moving higher are even greater, observers say.
“This is a time to be very careful,” said Lance Pan, director of investment research at Capital Advisors Group Inc. in Newton, Mass., which manages $7 billion in shorter-term paper for institutional investors.
He also worries that a bond bear trap could catch the unwary.
“If you think back to 2003 and 2004, we were in a 1% [short-end] yield-curve environment,” Mr. Pan said. “People were reaching for yield and that’s when auction rate securities gained in popularity.”
Prior to 2003, the ARS market was about $50 billion. By 2004, it was $200 billion, and by last year it was $360 billion, Mr. Pan said.
In February 2008, when ARS liquidity disappeared, the risks of extending duration by using the securities hit home.
“That’s a good lesson for us to learn,” Mr. Pan said.
Few observers doubt that higher rates are coming.
“If the Federal Reserve were not actively purchasing Treasury bonds, yields would be much higher already,” said Tim Anderson, chief fixed-income officer at Riverfront Investment Group LLC in Richmond, Va., an institutional manager with about $650 million under -management.
“Once they take away that support, you’ll see long-term yields jump substantially,” he said.
“The government is really the only buyer of this paper right now,” Mr. Pequet said.
Demand for Treasuries from China and oil-rich nations has already slowed, and individual investors won’t be able to pick up the slack, he said.
Treasury yields will have to rise to continue to attract buyers, observers said.
For now, clients can extend short-term bond durations by a year or two and “triple or quadruple their yield,” and by sticking with quality, they’ll have liquidity via the secondary market, Mr. Pequet said.
Meanwhile, tax-free money funds offer more than taxable products. And with banks seeking capital, there is a window of opportunity now to buy CDs with one-year terms or less that pay a full point over Treasuries, Mr. Pequet said.
Advisers need to temper client expectations in this low-yield world.
“A 2% return may be hard to swallow, but with 0% to 1% inflation, the real return isn’t that bad,” Mr. Pan said.
BIG CREDIT SPREADS
Meanwhile, historically wide credit spreads are tempting some advisers and investors to take on more credit risk in longer-term bonds.
Some see corporate bonds as good equity substitutes, especially if one assumes low equity returns going forward.
Investment-grade corporates pay more than four percentage points over Treasuries, Mr. Anderson said.
“That’s wide even for recessionary levels,” he said.
That spread has some room to shrink without major damage to corporate-bond prices, should Treasury yields rise, Mr. Anderson said.
Be especially careful with high-yield bonds, observers said.
Default rates on junk bonds will go much higher than the 12.5% seen in the 2002 recession, Mr. Anderson said, “but I think the brunt … will happen in lower-tier companies” that won’t be able to raise capital or roll over loans.
Last month, Standard & Poor’s Corp. of New York estimated that defaults on high-yield paper will reach an all-time high of 14.3% by March 2010.
“You’re still getting paid for taking credit risk, but you have to do it prudently,” Mr. Anderson said.
Mr. Pequet thinks that short- to intermediate-term, good-quality corporate paper looks attractive, but that the risks with lower-quality junk bonds are still too high. He thinks that default rates could go as high as 15% next year, and recovery rates in bankruptcy will drop below the normal 50% to 60% for secured paper.
The risks with junk bonds “aren’t fully factored into market prices,” Mr. Pequet said.
Mr. Pan agrees.
Bonds of “low credit quality we are especially worried about,” he said. “I don’t think any economist or credit analyst says the worst is behind us.”
E-mail Dan Jamieson at email@example.com.
By Dan Jamieson