Many experts believe that fixed income has become a high-risk asset class, more so than at any time in recent years. Demand has pushed bond prices way up and yields way down. Bond sales for 2012 are expected to break the 2009 record of $1.024 trillion. Investors’ average allocation to fixed income is 26%, double what it was in October 2007, according to Morningstar.
High demand has also led to a flood of issues with lower credit quality and less investor-friendly terms. While demand for bonds is expected to remain strong as long as the Federal Reserve keeps interest rates at historic lows, the stage is set for a crash when interest rates rise.
In addition, bond maturities are longer today than they were in 2009 ? the average is 11 years today versus 8 years in 2009, according to Dealogic. The longer the maturity, the greater the price sensitivity to interest rate changes. If interest rates rise just 1%, the average bond issued in 2012 will lose 5.12% of its value compared to a 1.82% decline in 2007, according to Barclays.
Another looming problem: Experts also see a liquidity crisis in the event of a big sell-off. When interest rates rise and everyone heads for the exit, there will be too many sellers and too few buyers.
For the first time in decades, bonds are being out-yielded by equities — investors can get more income from dividend paying stocks than bonds. The yield on the average double-A rated bond is 1.96% while the average dividend yield of the S&P 500 stock index is 2.33%. However, stocks are more volatile than bonds, and many income-oriented investors do not want to go there.
Abby Joseph Cohen, senior investment strategist at Goldman Sachs, is on record as saying that the next big move in bonds is down. Bonds can add ballast to a portfolio but the amount of ballast depends on the price/yield at which they were purchased. Far from adding any ballast, bonds purchased at today’s high prices/low yields will be part of the crash, according to a growing number of market observers.
Financial advisers that recommend bonds or bond funds to clients should thoroughly discuss these risks with clients and verify that the bonds are within the client’s risk tolerance levels.
Page Perry, LLC is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.