Once-safe option now hazardous

Even quality issues can be risky, experts warn bond investors

August 12, 2007|By Gail MarksJarvis | Gail MarksJarvis,Tribune Media Services

Bonds are supposed to give investors comfort when the stock market is falling.

But not this time.

Stocks have fallen since mid-July because of concerns that overextended homeowners and businesses won't be able to repay the loans they have taken out. That means billions of dollars in bonds are vulnerable and that people who invested in risky bonds could lose money.

Bonds are the IOUs investors receive when they lend money - often to a business or governmental body, but sometimes in a round-about way for home mortgages. And investors in bonds receive their interest payments and original money back in full only if the homeowners or others who needed the loan stay in good shape and keep paying their debts.

Investors in stocks and bonds are worried because homeowners and businesses have been taking on record levels of debt, even though the borrowers could be in over their heads and have trouble repaying the loans.

Worries are surfacing clearly in bond mutual funds that invest in mortgages, corporate bonds and bonds issued throughout the world. Although defaults remain relatively low, experts are urging investors to seek out the safest issues.

Both high-yield bond funds, which invest in bonds issued by shakier companies, and emerging-market bond funds, which invest in developing areas of the world, have lost money of late. And analysts are warning that tumult involving risky bonds is likely to continue.

According to Lipper Inc., which tracks mutual fund performance, the average multisector income fund - which invests in a variety of bond types - declined 0.95 percent in July, and 1.6 percent over the previous three months.

High-yield bond funds - or what are commonly referred to as junk bond funds - dropped 3.17 percent, according to Lipper, slightly more than the benchmark Standard & Poor's 500 stock index.

Investing in bonds overseas also has been treacherous. Emerging- market debt funds lost 1.37 percent last month as investors worldwide worried that investors have become cavalier during the past few years without properly weighing risks.

"While it is tempting to say the worst is behind us," value fluctuations "rarely stop on a dime," Morgan Stanley bond analyst Gregory Peters said in a recent report.

Standard & Poor's managing director Diane Vazza also has been warning investors that trouble may be ahead.

She noted in a recent report that "a decade-long shift toward more aggressive corporate financial strategies and continued evolution of the leveraged finance market has combined to shift our median rating" for nonfinancial issuers to BB in 2007 from BBB-minus in 1997.

That means the ratings that Standard and Poor's uses to help investors understand the risks they take in bonds show that more bonds are riskier now: BB means bonds are weaker than BBB. So people who buy BB-rated bonds should know they are taking on additional risk that they won't get their investment back. As Vazza surveyed the full U.S. corporate bond market, half were so risky they fell into the "speculative" category.

Worse, Vazza said, "the ratings mix continues to deteriorate as firms borrow to buy back shares and make acquisitions."

The key force in deterioration of the bond picture is the fact that lenders have poured significant numbers of weak bonds into the market during 2007.

In the first half of 2007, Standard & Poor's said, there was "record issuance in both the high-yield and leveraged loan markets, adding up to $452 billion in leveraged loans and close to $98 billion in high-yield debt."

If investors focus on the recent track record of companies for paying their debts to bondholders, they will see little reason for concern. The default rate - or proportion of companies failing to pay bond holders - is low, at only 1.22 percent, Vazza said. And Standard & Poor's is predicting just a slight increase in defaults by the end of the year - a rate of just 1.4 percent.

But that obscures the future.

"Based on the historical experience between 1981 and 2006, the glut of firms at the B rating levels poses significant default risk," Vazza said. "As the economy and corporate profit growth slows, firms rated B and below will come under more pressure to meet their obligations."

Investors have grown increasingly aware of these concerns as the number of people unable to pay mortgages has increased and foreclosures have mounted. If household finances are being strained by mortgage problems, consumers are likely to reduce spending.

"The economy has already been growing below trend for a year, and that will continue for a few more quarters," said researchers in a report in The Bank Credit Analyst. "The naive view that the housing downturn would be short-lived with limited impact on the economy has been thoroughly discredited."

Against that backdrop, bond fund managers have been warning individuals about taking chances in bonds.

"It's tumultuous," said Mary Miller, head of fixed income at T. Rowe Price. "In the short term, buy quality."

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