Investment-grade corporate bonds were the new black this winter.
These are the IOUs issued by strong, well-financed companies like Exxon Mobil and Johnson & Johnson. Almost every investor wanted them, and almost every adviser recommended them.
"You can't go anywhere without someone telling you, 'You should own investment-grade bonds,'" jokes Larry Glazer, managing partner at Mayflower Advisors in Boston.
While ordinary investors yanked about $57 billion from their stock market mutual funds during the first quarter, they put about $38 billion into taxable-bond funds, according to the Investment Company Institute. Much of that went into Treasury bonds; a lot also went into top-rated corporate debt.
But beware of any investment consensus. There are advantages to investment-grade bonds, but there also are risks that don't get so much attention.
The appeals are obvious. In these turbulent markets, many people believe investment-grade corporate bonds offer good returns with low risk.
Standard investment theory, as well as a lot of past experience, says corporate bonds are safer than equities. You don't have to rely on uncertain capital gains for your returns. Bonds pay regular interest instead. And if a company does get into trouble, bond holders will get all their money back before stockholders see a penny.
Bonds issued by the strongest companies -- like IBM and Pepsi -- are pretty secure. Those companies are unlikely to go broke anytime in the foreseeable future. Yet their bonds pay a lot more than those issued by the U.S. government. Right now the yield on Moody's index of AAA rated corporate bonds is about 5.3%. Ten-year Treasurys: Just 2.75%.
The gap, or "spread," between the two is pretty good by historic standards.
So far, so reasonable.
But these bonds also come with risks as well.
The first and most obvious is any rise in inflation. This is a serious danger to investors in all bonds right now, including corporates.
Who will want a piece of paper paying 5.5% for 10 years if prices start rising 6% a year and savings accounts pay 8%? Nobody, of course.
Should that happen, the price of these bonds would fall until they became attractive again. This is what happened in the 1970s. Anyone forced to sell will lose money in nominal terms, while anyone holding on until the bond matures will lose in real terms.
Equities fare less badly under inflation. That's because earnings, and dividends, can rise.
Right now, of course, inflation is low. But it's a real danger ahead.
The government is printing vast amounts of new money and pumping it into the economy. It is also running huge deficits. Under the normal rules of economics both would stoke price rises in due course. And there's an argument for saying the real cost of living is already rising far faster than the official numbers suggest.
The big corporate bond bulls argue that investors are already getting compensated for the risk of inflation, because these bonds pay so much more than Treasurys. The problem? That assumes Treasurys are fairly priced. And that's a dubious assumption at best. Treasury yields are near historic lows. Anyone buying Treasurys here, especially the longer-term ones, is taking a big gamble on very low inflation for decades to come.
Inflation isn't the only danger to investment-grade corporate bonds either. They also pose at least some credit risk.
Even top-rated companies can get into financial difficulty -- especially if we face prolonged economic turmoil. As we have seen in the last 18 months, the unexpected happens all the time.
And even a downgrade can hurt the price of top-rated paper. The price of the bonds usually falls when that happens.
It's true that bondholders get repaid before stockholders in a bankruptcy, that doesn't mean they emerge unscathed. Holders of General Motors bonds will be lucky to get fifteen cents on the dollar for their money if the company goes into Chapter 11. That's better than the stockholders will do, but not much.
While bondholders take on some risks, they miss out on the big gains if things go well. Shareholders in Apple and Google and Exxon have made a lot of money over the years, because they own all the profits.
Regular bonds only ever pay out principal and coupons, no matter what happens to the company (though of course they can at times be traded for a profit).
There's a perfectly good case for holding some investment-grade bonds in your portfolio. But be very wary of any suggestion that they are a straightforward one-shot solution. Investors are taking on more risks than they may sometimes realize. They need to make sure they are getting compensated for them.
