Portfolio Update

Buying Bonds in a Sellers’ Market

The Federal Reserve looks like it will raise its benchmark federal funds interest rate again. And Wall Street is abuzz with talk about faster economic growth and potential inflation now that Congress rounded up the votes for deficit-funded tax cuts.

In the bond market, however, it’s still all about supply and demand. Investors who must buy still greatly outnumber companies that must sell. The result is limited availability of attractive bonds, which pushes up prices and drives down coupon rates—i.e., investor returns.

The buying power has increasingly come from pension funds and ETFs (exchange-traded funds) driven by rapidly growing passive investment strategies. The more investors near retirement age, the greater the portion of bonds these vehicles must hold. Therefore, the more often those funds must come to market and buy.

Meanwhile, for nearly a decade, companies rated investment grade by Standard & Poor’s, Moody’s and Fitch have taken advantage of generational low corporate borrowing dates to issue new debt with longer maturities and at lower interest rates than existing debt. The result is greatly strengthened balance sheets and reduced near-term refinancing needs.

Even many junk-rated companies have borrowed for longer at lower interest rates. The yield spread between investment and sub-investment grade debt has shrunk toward historic lows. Consequently, supply of junk bonds has shrunk as well.

This is all great news for investors who bought bonds in past years. Finding new or even older issues with an attractive combination of yield, safety and potential upside, however, has become exceedingly difficult.

Major buyers have been forced to buy whatever they can get. That’s meant taking on less creditworthy debt paying out less income. And the result for investors is lower returns and higher risk, particularly in open-end mutual funds and ETFs that must invest the dollars that come in.

One solution for retail investors is to buy individual bonds that are still cheap for one of three reasons:

• The trajectory of the issuer’s underlying business is higher than its current credit rating, meaning upgrades are likely in the next 12 to 18 months.
• The issuer is in an industry that investors currently shun because of rivals’ weaknesses the issuer doesn’t share.
• The issuer’s management has the equivalent of a silver bullet that, if used, can dramatically improve financial metrics.

Such bonds aren’t easy to find. And if one does find them, there may be strings attached, such as limited liquidity or being only available to qualified investors.

If you insist on paying only at or below a certain price (as we do), you may have to wait some time for the order to be filled.

Two Portfolio Picks

We highlight high-yield bonds that are current buys in the latest issue of Capitalist Times Premium’s sister letter Deep Dive Investing. Our two holdings in this publication’s Lifelong Income Portfolio, however, are both funds.