2013 Bond Market Forecast: Is the Bond Bubble Finally About to Burst?

Money Morning Article of the Week

By Shah Gilani, Capital Wave Strategist, Money Morning

[Editor’s Note: Here’s a question that has vexed investors for years now. Everyone says rates have nowhere to go but up and all they have done is fall. According to Shah, this actually could be the year the bond bubble bursts.]

The Federal Reserve‘s multi-year prescription of targeting super-low interest rates on federal funds, along with various quantitative easing programs, has pushed yields down on all fixed-income instruments to the benefit of issuers and the detriment of investors.

There is little doubt that the Fed’s articulated and executed policies have resulted in a bond-bubble with both short and long-term consequences for investors and the economy.

At some point the bond-bubble will burst. But there is no certainty on when that will happen or what ultimately will cause rates to rise.

What investors need to understand is that while yields and bond prices in 2013 could remain flat relative to closing third quarter 2012 measures, yields are unlikely to fall further and prices are unlikely to rally in 2013, with the possible exception of short-term U.S. treasuries.

However, there is the possibility of what I’m calling a “skyfall.”

For fixed-income investors this means there is a chance the bond bubble may finally burst.

2013 Bond Market Forecast: From Flat to Skyfall?

Skyfall is the title of the latest James Bond film, which viewers discover is also the name of Bond’s childhood home in Scotland, before it is blown apart in the movie’s climactic finish.

Now, because interest rates across the board have fallen to historically low levels, the great bond rally could suffer a similar climax.

Here’s where we stand now, why the bond rally is likely over, what could happen in 2013, and what early warning signals to watch for to get out of the way of this skyfall.

As yield-hungry investors have plowed more and more money into bond mutual funds, bond ETFs, and, for institutions, individual bonds, issuers from sovereigns to junk dealers have rushed to the market to soak up the trillions of dollars searching for yield.

That circuitous path has kept money flowing into bonds in search of falling yields as issuers take advantage of low rates artificially manipulated by the Fed’s actions.

All dollar-denominated bonds issued in the United States (and many issues globally) are priced off the U.S. Treasury yield curve.

That’s the scale of interest rates that starts with the federal funds rate (even though the Fed doesn’t issue fed funds) and displays the interest rates payable on Treasury bills, notes and bonds, up to and including the most actively watched, traded and talked about 10-year T-bond, all the way to the 30-year T-bond.

Treasury issues are considered “risk-free” because they are backed by the full faith and credit of the U.S. to pay all interest and principal on its debts.

All other bonds yield more (pay more interest) than equivalent-maturity Treasury issues to reflect the difference in “quality” between a Treasury issue and a municipal, corporate, or other bond issue.

The difference between what a Treasury’s yield is for a particular maturity bill, note or bond and what the yield is on another issue is called the “spread.”

The spread refers to the additional yield (the difference in the interest rate) issuers have to pay to attract investors who otherwise might opt for the safety of Treasuries.

As interest rates have been kept artificially low, investors looking for additional yield above exceptionally low-yielding Treasuries have been increasingly willing to accept smaller and smaller “spreads” when they buy bonds that aren’t risk-free.

Issuers recognize investor demand for yield and know investors will still buy their bonds even as they offer less and less interest, because whatever yield advantage investors can get, they will gladly take.

As a result, the spread over Treasuries has come down for all issuers from top-rated investment grade issuers to leverage bond and junk issuers.

In other words, investors are not being adequately compensated for the increasing risk they are taking with issuers, who range from investment-grade corporations to special-purpose vehicles issuing junk bonds for leveraged and speculative endeavors.

The Fed’s recent announcement that they will buy $40 billion per month of top-rated agency paper (mostly mortgage-backed-securities), only takes even more U.S. government-backed paper out of the market, leaving investors clamoring even more for whatever investment-grade (“IG”) bonds they can get. That’s a further boon to bond issuers.

In fact, in just the third quarter of 2012 (the latest quarter for which data is available) IG issuance, excluding sovereign, supranational, split-rated and preferred-stock issues, exceeded $215 billion – a near record.

But that’s IG. What’s more telling, and evidence of how much investors are reaching for yield further out on the risk spectrum, is what third-quarter issuance was in the leverage and high-yield (junk) markets.

Leverage loans are loans and bond issues backing loans to corporations, companies and other issuers that already have high leverage on the debt side of their capital structure. High yield, also known as junk bonds, are debt issues offered by the most speculative issuers seeking debt financing.

Leverage bond issuance totaled $114 billion in Q3, a record, which included a constituent record $20 billion issued in August, historically the year’s slowest month.

At the current pace, with $317 billion already issued year to date, leverage loans are on track to reach $423 billion, or exceed $508 billion if September’s $63.5 billion pace continues.

And while the leverage loan market has been flush, the high-yield market has been doing its own hot issuance thing.

Bond-clearing yields fell in the third quarter to all-time lows, even though spreads are still above record lows. High-yield issuance in the third quarter was $91.9 billion, the second highest on record. The highest quarter ever was this year’s first quarter at $99.9 billion. Full-year 2012 junk issuance is closing in on the record $287 billion issued in 2010, and likely to exceed it.

Combined leverage and HY issuance in all of 2012 is expected to exceed $748 billion, topping the former record of $679 billion reached in 2007.

We Know What Happened Next….

With rates so low and investor appetites still high, we’re seeing more and more “covenant-lite” deals, the ones that afford more protections to issuers than to investors.

Investors need to look through the froth in the bond market and realize that a lot of bonds are issued with call features and are in such demand that they are trading at premiums to par value, or what will be returned at maturity.

It’s imperative that investors realize that coupons, or the interest rate that a bond comes to market with, is different than what you will get on a yield-to-maturity basis if you pay a premium, or especially if you pay a premium and the bond is called long before you expect to have held it.

With prices so high and yields so low, all relative to the risk of holding bonds in a bubble-like market, investors need to have an exceptionally strong stomach to wade into the bond market now or in 2013.

Investors also need to beware of false rallies.

The risk-off trade, where equity investors flee to the safety of Treasuries, could make Treasury prices rise and bonds look like a safe haven. They could be, for a while.

Then there’s the outside threat of inflation that would cause rates to rise and bond prices to plummet. Or the move to the risk-on trade, which would signal that equity investments are preferred to the low-yielding safety of bonds, which could decimate bond prices.

Or there’s the chance that the economy double-dips in 2013, putting pressure on leverage loan and high-yield issuers to make interest payments at the same time that investors flee their bonds and raise capital structure costs for them.

I’ll be watching the derivatives markets, namely the credit default swap indexes like CDX-IG-19 to see if default insurance costs start rising, by how much, how fast, and on which indexes.

I’ll leave a light on for you, and shout out loud here and in my services if the bond vigilantes start gathering at the end of town.

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Opinion and Investing articles by Shah Gilani

About the Author

Shah Gilani is the managing editor of Wall Street Insights & Indictments, a seasoned veteran of Wall Street and former hedge fund manager. During his career, he was a successful trader and held a seat on the Chicago Board of Exchange, gained knowledge from the desks of Lloyd’s Bank and gained experience from New York and Boston investment banks and trading houses. For a free online subscription to Wall Street Insights & Indictments, please contact: [email protected]