Investors Are Descending Into The Five Circles Of Bond Hell

Bond investors are struggling to find a decent yield in this environment of low interest rates.

U.S. 10-year Treasury notes currently yield about 2.5%, just slightly better than the just-less-than 2% inflation we’ve seen over the first half of this year.

As a result, bond investors are left with only bad — or at least, suboptimal — options right now.

Peter Tchir at Brean Capital published a research note on what he calls “The Circles of Bond Hell.”

There are five:

1. Hope Market Cheapens: Some folks are just waiting for bond prices to fall and yields to rise. But if your investment strategy has come down to “Hope the Market Cheapens,” you have no investment strategy. You are going to church. Tchir: “While this strategy has the appeal of being risk averse, it hasn’t worked at all.”

2. Increase Duration: If you are forced to increase your duration, you’re exposing yourself to interest rate risk. And in (overly) simple terms: When short-term rates rise, the stuff you own that doesn’t mature for a really long time is worth less. Tchir: “This seems to be fraught with career risk at this stage.” This sounds appealing.

3. Decrease Credit Quality: This forces investors to take a step down. So an investment-grade investor buys high-yield corporate bonds, which carry more default risk but yield more, and a government-bond investor buys investment-grade corporate bonds, and so on. Tchir: “While dangerous, this remains a viable way to increase yield — assuming the central banks continue to support the markets and the economy muddles along.”

4. Give up Liquidity: Basically, you gotta buy stuff that’s harder to get rid of in order to get returns. This is scary because you can’t get rid of things when the market turns against you. Tchir: “It does mean that your credit decisions have to be better than otherwise, because you likely own this in a down market.”

5. Increase Structure: Buy more complicated stuff. Buying an asset-backed security, which might include some auto loans, mortgages, and other things, instead of buying a high-yield corporate bond from one company. But the more stuff you’ve got, the less you know about how to use it, basically. Tchir: “This is the next most logical step … This is where the value is and where investors will be forced to move as it is the best option left to increase yield.”

In our most recent Most Important Charts In The World feature, Tchir contributed this chart, which shows where we are in the bond market cycle.

According to Tchir’s schematic, we have a world of bond investors finding value where no one else can, but we are short of having a glut of credit geniuses.

For now.

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