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Ignore bonds at your own risk

With narrow spreads between the yields for bonds rated high-quality and low-quality, Kyle Tetting says investors should make sure they’re getting paid for the risks they’re taking – especially with what’s considered the safer side of their portfolio. Kyle spoke with Joel Dresang in a Money Talk Video. A transcript of their conversation follows.

Joel Dresang: Kyle, let’s talk about bonds. They’re part of a well-diversified investment portfolio. Um, historically, they’ve helped control risk, while also adding return to the overall portfolio. How do they look these days?

Kyle Tetting: You know, Joel, in the midst of what has been a pretty exceptional bull market, it’s pretty easy to discount the role that bonds have played, but an important piece of risk control for portfolios. And I think the challenge that we face right now in ignoring bonds for as long as we’ve been able to ignore them is that as those risks start to make their way back into the market, we may not be pricing them appropriately.

Joel: What kinds of risks are you talking about?

Kyle: You know, Joel, I think the biggest risk is that spread between higher-quality bonds and lower-quality bonds, that if you’re going to purchase something that’s lower quality, you really want to be compensated to take that additional risk. Because lower-quality issuer, or a company that might not be doing as well financially, has a higher probability of potentially defaulting or even delaying some payments on that debt.

So, really important that investors pay attention to that spread – the difference between the yield on the higher quality and lower quality – to get an idea of whether or not they’re being compensated for the risk they’re taking.

Joel: How can I as an investor know how that looks in my portfolio?

Kyle: So, we have tools through Morningstar that allow us to provide a snapshot of client accounts to see what kind of allocations an investor has to different credit qualities, to different types of bonds. These are things that an investor would know if they’re buying an individual bond. They can look at the rating agency and see, how does the rating agency feel about this particular issue, this particular corporation? And then, when you start to put it together into a portfolio, you need some of those more sophisticated tools to look through and get the picture in aggregate.

Joel: And is this picture shifting over time?

Kyle: The composition of the bond market has changed pretty drastically. You look at pre-financial crisis, the corporate bond market was 30% BBB debt. That’s the lowest quality investment-grade debt that’s available. Now, about 50% of the corporate bond market is that BBB debt. So, really what we’re looking at is that the issuance itself has gotten a little bit riskier.

And so, I think there is some concern that we’ve seen a lessening of the quality of the issuer in recent years.

Joel: Are you seeing any encouraging signs in bonds?

Kyle: You know, Joel, I think the good news is that we’ve seen pretty substantial improvements in corporate balance sheets. So, corporations are far healthier than they were during the financial crisis. Even those BBB issuers that we talked about are in better shape than they were.

The other really good piece of news for corporations is that they were able to issue debt years ago with very low interest rates, able to borrow at a time when it wasn’t very expensive to do that, and so, they’re still reaping the benefits of those lower borrowing costs.

Joel: So what should investors be doing right now about bonds?

Kyle: Ultimately, if we’re in an environment that rewards stocks, and if we’re in an environment where bonds really aren’t compensating investors for the risks that they take, especially in those lower quality bonds. The focus for investors should be to keep their safe money safe, to make sure that if they’re going to have a portion of their portfolio in bonds and fixed income that’s the portion that isn’t taking unnecessary risk.

You know, ultimately, what we’re concerned about is keeping that safe money safe, and understanding that bonds are there for the return of your money and not the return on your money.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May and Jason Scuglik

Learn more
Watch credit quality as spreads narrow, a Money Talk Video with Marc Amateis
Bonds also face investment risks, a Money Talk Video with Tom Pappenfus
Be patient holding bonds as rates rise, a Money Talk Video with Steve Giles
Tips Before You Invest in Bonds, from the Financial Industry Regulatory Authority

(initially posted August 20, 2018)

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