Once-safe option now hazardous

The Baltimore Sun

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."

But, she notes, even quality bonds have been getting hurt. Some, such as Ginnie Mae, Freddie Mac and Fannie Mae mortgage bonds, have been tarnished by association in the troubled housing environment, she said. They are not the risky subprime collateralized mortgage obligations that have become almost worthless and caused hedge funds to fail. But because so-called federal agency bonds such as Freddie and Fannie bonds are mortgage-related, some investors have dumped them anyway.

Although current investors are losing money on them, Miller has been buying them. Bond yields have risen to compensate investors for taking the risk. So she has been picking up about half of a percentage point more in yield, on a relatively safe investment, than she was able to do a few weeks ago.

When investors become frightened they flee anything that appears risky and buy very safe investments.

As a result, they are pouring money into U.S. Treasuries, which are among the safest of investments - along with certificates of deposit and money market funds. But with demand soaring for U.S. Treasuries, yields have dropped. The yield on 10-year Treasuries was at 5.295 percent on June 12 and 4.8 percent on Friday.

When demand grows intense for safer investments, yields go down. So investors might be tempted to buy corporate bonds for higher income.

Henry Hermann, chief investment officer of Waddell and Reed, advises against that now.

"The need for income caused a lot of people to chase yield, and that's what caused the problems we are seeing playing out now," he said.

As investors sought yields higher than those of U.S. Treasuries, they became increasingly relaxed about taking risks and poured money into high-yield corporate junk bonds and the risky subprime mortgages that have been going into default.

Hermann notes that the market probably has several months ahead in which those investments will go through spasms. The prices on them will fall, so investors in them or funds invested in them will lose money. And junk bonds will start paying higher yields to compensate people for taking risks.

While this change is under way, he says, individuals should be very careful.

"If you have cash, I wouldn't put it to work yet," he said.

Meanwhile, investors in corporate bonds need to pay specific attention to the firms that have issued the bonds, says Morgan Stanley's Peters.

"The message in the markets is that pain will continue to be felt by those borrowers in need of liquidity," or the need to borrow money, he said.

"For the brave souls looking to re-enter the markets, we feel a great way to differentiate is by simply looking to add companies with ample free cash flow, and avoiding those names with negative as well as volatile free cash flow," he said.

Generally, Peters said, that would mean to be more cautious about homebuilders, media and retailing, compared to energy and health care companies.


Gail MarksJarvis writes for Tribune Media Services.

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