Investment bonds come under scrutiny worldwide

Despite the drama of the financial crisis of 2008, the investment bond market has enjoyed success. But now a wind of inflationary change is about to blow.

The key question is: What will bond investments rate in a year or two’s time, given that after almost 10 years, interest rates are showing signs of rising?

It’s an interest rate debate all about world economies, employment levels and inflation. Bond investors know how sensitive bonds are to interest rates.

Low inflation benefits investment bonds

Average world prices for investment bonds have risen for at least the past two decades as interest rates have fallen, which, aided by government quantitative easing, have reached almost zero levels.

Bond consultant Richard Kemmish comments: “There is a consensus that the low inflation period we have been experiencing is coming to an end as economies recover

“The US is the first to pull away and with growth comes inflation which will push interest rates up as 2020 approaches.”

Desperately seeking bond income 

After such a long while, today, investors are hungry for income and they are prepared to take on more credit risk to get it. Many buy bonds from higher risk issuers, or they buy bonds that carry more risk from middle of the road issuers.

In tandem, there is a growing market for high-paying bonds. High-yield bonds on offer in the first seven months of 2017 - reached the same volume as for the whole of 2016.

Bonds with a credit rating below ‘triple B’ are not considered ‘investment grade’, but various companies below this level are bringing in buyers keen on worthwhile returns.

Take for example the UK’s eighth largest restaurant chain Wagamama. In June, it raised £225m offering five year bonds at 4.125% interest, even though its credit rating is only a single ‘B’.

Riskier investment bonds?

Many companies, often the more speculative, have issued bonds with investor protection using promises or ‘covenants’ to keep certain financial ratios or with security over certain assets.

But given the demand for bonds, the pressure to provide covenants has diminished.

US bankers frequently talk about the rise of ‘covenant-lite’ bonds, which provide the buyer with less protection than before.

Subordinated bonds

It is an irony that banks don’t like bonds that are thin on covenants, but they like to offer clients so-called ‘subordinated bonds’. A subordinated bond is like an unsecured loan and will be bottom of the pay-back pack, should the bank fail.

A sorry example of this is Banco Popular, Spain’s 5th largest bank. It collapsed in June and was rescued by Santander. Its subordinate AT1bonds totalling €1.25bn became worthless.

Investment bond prices have been rising so much that the average high yield bond now yields 2.7% over the traditional ‘risk free’ benchmark rate which is the yield on German government bonds. The spread between the two has never been as wafer thin as it is now.

Back in 2006, well before the credit crunch, bond interest rates were around 5%. The US Federal Reserve has seen no change in policy for over 10 years, but the view is that a return to pre-crunch polices is getting under way, slowly.

The future for bonds looks steady

Viktor Nossek, director of research in Europe at fund house, Wisdom Tree, views the future for bonds as stable. “We should see no dramatic changes in the next two years, assuming oil doesn’t do something unexpected,” he says.

“In two to three years we could see a doubling of interest rates from 1.25% now to 2.5% in the next two years.”

_{The Federal Reserve. Source Shutterstock}

“US employment is high, we are not seeing a sharp increase in inflation so, at the moment, there isn’t a great probability that inflation will rise dramatically. In two to three years we could see a doubling of interest rates from 1.25% now to 2.5%.”

In Europe, Nosseck thinks economic change is likely to be slower than in the US because it is so much more dislocated.

He feels EU fiscal policy should be carefully unwound with no government ‘tapering’ of quantitative easing (bond buying) as the Federal Reserve did in 2013 when it ‘tapered’ or reduced its bond purchases.

Be careful investing in riskier bonds

Bonds used to be considered a relatively profitable and safe home for money: if anything a bit of a boring form of investment. 

They have been characterised in the last 10 years by their low yields, typified by German bonds or bund which are regarded as safe as a sub-terranean vault, but absurdly over- priced. 

Said one experienced bond commentator, “There comes a point when it doesn’t make sense to invest in a highgrade bond because there is no income, no upside.”

The search for income by investors has shaken the bond market up a bit. Investors have shown an appetite to take on more risk and accept worsening credit conditions.

With the newfound fashion for high yield bonds, investors have to watch out for the downside of riskier bond offerings.

Viktor Nossek counsels: “Bond investors should be diverse when buying in Eurozone bond markets. It’s a case of spread your bets.

 “Don’t assume that your usual bond safe haven (perhaps UK gilts), is guaranteed. Be prepared to look for a lesser safe haven, go for eggs in more than one basket for diversity or go short to hedge your bond exposure.”

_{Viktor Nossek, Head of Research, Europe for Wisdom Tree.}

You could argue that bonds are aapproaching a cross roads. No one is sure of the route. If those who think inflation will become a part of everyday life again, then maybe investors in bonds will be less enthusiastic than now.

When investors receive reasonable interest on something as ordinary as a bank savings account, they won't have to try so hard to look for income elsewhere. Perhaps bonds will go back to being - a bit dull.