High-quality bonds have been a bastion of strength and consistency in client portfolios for years, delivering high single- and double-digit returns with nary a hiccup along the way. These returns have been supported by the secular decline in interest rates, and, more recently, by the dramatic compression of yield spreads in the aftermath of 2008. This spread tightening in the credit markets was facilitated by the recovery of credit fundamentals and declining default expectations once the economy stabilized after the Great Recession.

Today, with yields standing at never-before-seen levels in almost every corner of the fixed-income universe, it is mathematically impossible to generate the kind of capital gains credit investors have enjoyed over the past few years. For this reason, many market practitioners believe 2013 and beyond will deliver coupon rate returns from the bond market at best.

This outlook brings an especially worrisome set of prospects for the high-quality bond market. With rates at exceptionally low levels, there is little cushion from yield spread on typical high-quality bonds to offset even marginal increases in interest rates. Furthermore, there has been a dramatic amount of investor flows into this space over the last few years, suggesting allocations may have accumulated in high-quality bonds as a substitute for zero-percent-yielding cash. If returns in 2013 and beyond come in at subpar coupon rates at best, and offer negative rates at worst, then there could be a “Great Reallocation” to other asset classes, prompting a giant flush of securities and widening spreads as a result. Even a small reversal of the dynamics supporting high-quality bond market returns—a faster-improving economy or shifting technicals—could spell serious trouble for the asset class.

Vigilant advisors need to ask: Are these risks really imminent, and what will be the real harm to clients invested in high-quality bonds as a result?

Certainly, the Federal Reserve has made it very clear in its communications that it intends to keep interest rates as accommodative as possible given the subpar economic growth and high unemployment. The Fed’s communications seem to suggest 2015 will be the year interest rates rise, though we know rates can and will move in anticipation of official policy or in reflection of shifting inflation expectations. For sure, Treasury yields have already shown that they will increase rapidly in the presence of stronger economic data or even with the smallest intimation of a change in course by the Fed.

Just recently, up until the events in Cyprus unfolded, followed by the dismal March jobs report, yields were on the rise, increasing almost 50 basis points from 1.59% on the 10-year Treasury note in December to 2.07% by mid-March. This move was predicated on just two months of strong payroll data and a Federal Open Market Committee statement sparking speculation that quantitative easing may end in midyear now that there has been substantial improvement in the labor market. While it is true that rates have since round-tripped back to their previous lower levels, at some point yields are going to move higher, and the impact on market values will be dramatic.

Consider that if rates on a five-year Treasury note rise by 100 basis points, investors will suffer a mark-to-market loss equivalent to seven years of promised yield (4.9-year duration implies a 4.9% loss, which is seven times greater than the current yield to maturity of a five-year Treasury note at 0.71%). For this reason, low-yielding government bonds like these are consistently identified as the most unattractive segment of the bond market today.

Nor are high-quality credit bonds immune to rising rates; they may be just as vulnerable if there is surprise growth or if the Fed alters its guidance for either quantitative easing or the short-term interest rate policy. While high-quality bonds have historically had a low 0.19 correlation to interest-rate-sensitive securities in studies from 1980 to 2013, the market dynamics are shifting. The future correlations will be much higher since investment-grade credit has a minimal yield spread cushion, and therefore a bigger sensitivity to interest rates. An observation of 2013 price action demonstrates this shift: This time, high-quality credit bonds showed a 0.83 correlation with interest-rate-sensitive Treasurys in the first quarter of the year.

The impact of this shift should not be understated. Normally, credit investors have an advantage over Treasury holders: Spread compression partially offsets negative interest-rate market moves. Naturally, the wider the spreads, the deeper the cushion offered. Today, the limited spread cushion available on many categories of high-quality bonds is a big worry. Spread tightening since the post-Lehman flight to quality has been dramatic, such that most bonds look historically rich at current levels. Amazingly, in 2008, the average “A”-rated corporate bond had an 8.5% yield; today, that same quality bond is yielding 2.9%. Meanwhile, investment-grade “BBB”-rated bonds were 10.0%, and now they barely clock in above 3.7%.

Furthermore, while one normally considers spread widening events in conjunction with a downshift in the economy and a turn in fundamentals, this is not always the case. As rates start to rise, investors typically rotate out of high-quality bonds in favor of other investments like equities, creating a poor technical environment for spreads despite the bonds’ underlying credit strength. This kind of capitulation trade can wreak havoc on market dynamics, which heretofore have been powerfully in favor of high-quality credit bonds for supply-demand reasons.

Capitulation in a selloff may be among the most dire risks facing the high-quality bond markets, but even if rates continue to remain range bound, there are other concerns. For example, event risk is now a more looming worry than ever. Issuers with strong balance sheets are pursuing cheap debt-financed M&A and share buybacks in 2013.

Michael Dell, for example, has taken his company private and Warren Buffett and 3G Capital have joined forces to do the same with Heinz. While these two transactions are unique, investors are now suddenly worried about LBO risk, since these types of deals by large, high-quality issuers would have been inconceivable several months ago.
No longer are bond covenants with $101 change-of-control puts good protection for investors in this current low-rate environment. Indeed, with the average price of a bond in the Bank of America/Merrill Lynch U.S. Corporate Index trading at approximately $112.87, a $101 put price would surely be of poor consolation to a bondholder if a corporation took action.

For all of these reasons, high-quality credit bonds may be among the riskiest of fixed-income investments to make in 2013. While abandoning the asset class is not a prudent course given its role as a long-term stabilizing investment in a diversified portfolio, it should certainly be underweighted now. Instead, investors should give preferential treatment to higher-yielding segments like junk bonds, leveraged loans, international and emerging market debt—or equities. Investors should also consider a more dynamic high-quality bond allocation than they have in the past. Strategic or dynamic fixed-income allocation mutual funds that eschew interest-rate risk in favor of credit, currency or curve risk are a solid choice given these concerns, especially an allocation managed with a target duration of less than two years.

Another good option is a long-short credit fund, which zeroes in on the most compelling securities within a capital structure, going long on research-driven ideas with an identifiable catalyst while shorting overvalued, poorly structured bonds. Finally, investors may be able to protect principal with a portfolio of bonds purchased directly that includes carefully selected fixed- and floating-rate securities. This way, the investor won’t have to worry about the actions of other shareholders in a fund, and the investor will be able to conservatively manage interest rate and credit risks based on his or her own preferences and tolerances.

Ultimately, the risk of high-quality bonds in 2013 is likely to be more than what some have bargained for, though without a sharp spike in interest rates or a drastic turn in the credit cycle, the losses, like the gains, may be muted.
Clients must be cautioned, though, about the risk potential and recognize that, contrary to popular belief and recent experience, high-quality credit bonds are not a portfolio fail-safe for all market environments. 
recommendations.

Michelle Knight is Chief Economist and Managing Director of Fixed Income at Silver Bridge (www.silverbridgeadvisors.com), a wealth management boutique.