Please ensure Javascript is enabled for purposes of website accessibility

Kevin Fusco: Bond investing can be intimidating for some

It isn’t often that one can truly categorize anything about investing as unique.

There are facets that occur only rarely, and even some that happen quite frequently that average investors see as new every time they transpire.

Yet on rare occasions, the financial markets do provide something that has never been seen before, and may never be seen again. Right now that very phenomenon is happening in the United States Treasury market, with the yield on the 10-year Treasury note having recently fallen to a record low of 1.4 percent.

While the causes that surround this historical decline are important, and with the effect that it has on debt financing also offering incentives, investors should be asking themselves what this precipitous drop means to their portfolios as well.

Bond investing can be intimidating for the many investors who do not fully understand the basic relationship that exists between price, coupon, maturity and credit quality. Add to that the size and scope of fixed income markets, with the bond markets roughly twice as big in terms of capitalization as stocks, and inevitably many investors ignore the opportunities that the current interest rate environment present.

Flocked to bonds

Given the historical relationship between bond prices and yields, it is not hard to deduce how the current yield on the 10-year treasury has fallen so far. Investors have flocked to bonds issued and guaranteed by the United States government as equity markets have been rattled by four years of volatility. This influx of cash has driven prices higher, and inversely, yields lower.

Basically, many investors are now willing to pay well above par value of the average 10-year Treasury note for a yield that is lower than the inflation rate, as measured by the Consumer Price Index. While this may sound mildly absurd, it is the premium some are willing to pay for safety.

For those investors who seek a higher income yield, the choices require them to move down the credit scale, and away from the implied safety of U.S. government securities. Investment grade bonds (rated BBB or higher) issued by government agencies and corporations will offer relatively higher yields for commensurate risk, as will municipal securities that may offer additional tax advantages as well.

While maintaining a diversified investment-grade portfolio may seem like the ideal solution to a low-rate environment, remember that governments and corporations alike have taken advantage of the same circumstances to restructure their debt offerings at lower rates for longer terms.

To find rates at the highest end of the spectrum, it is necessary to venture into non-investment grade debt, or high-yield bonds. Often pejoratively labeled as “junk bonds,” high yield bonds are issued by companies, and some municipalities, with less than stellar credit ratings (BB or lower).

Since the risk of default is higher, so is the rate offered to investors. While high-yield bonds offer no guarantees, the anticipated default rate for 2012 of 1.5 percent is well below the historical norm, and much lower than the 10 percent default rate that plagued 2009 in the midst of the financial crisis.

Less traditional areas

Finally, the search for yield has led to some less traditional areas as well. Debt issued by emerging market countries has found favor, especially given the low rates offered by U.S. securities and the downgrades sweeping through European countries.

While international and emerging market investing involves special risks such as currency fluctuation and political instability, and may not be suitable for all investors, they also offer a premium over low domestic yields.

Also, floating rate debt, often used to finance short-term corporate cash needs, offers a premium to guaranteed debt, but comes with significantly more risk as these loans often tend to move more in step with stocks than other bonds.

While these options may be suitable for a diversified portfolio, realize that diversification alone won’t protect against loss, and that past performance is not an assurance of future results, and thus every investment position should be carefully reviewed before investing.

In regards to stocks, and to shed even further light on how unique this interest rate environment really is, the current yield on the S&P 500 Index, which cannot be invested into directly, is approximately 2.08 percent, which is more than 0.5 percent more than the current yield on the 10-year U.S. Treasury note.

Evidently investors’ appetite for perceived safety has clouded the premium that stocks may offer, and often at valuations far less than what is currently being paid for many bonds.

Kevin Fusco is senior vice president of Fusco Financial Associates Inc. of Towson. He can be reached at 410-296-5400, extension 109, or Kevin.Fusco@LPL.com.