Why safe corporate bonds aren't so smart anymore

May 29, 2011 - 1:44 PM

NEW YORK (AP) — The safest corporate debt isn't looking so smart anymore.

Companies deemed good for the money are raising trillions selling bonds to investors who can't seem to get enough of them. It looks like a great deal for both parties — until you consider the details.

Some bonds are throwing off interest so puny that investors are already losing money to inflation. Others pay higher rates but won't return your money for more years than you're likely to live. Johnson & Johnson just sold $4.4 billion worth of debt with fixed rates as low as 0.7 percent, 2.5 percentage points less than inflation. The prospect of near-free money was so irresistible to Google Inc., it decided to sell $3 billion worth, even though it already had more than 10 times as much cash at its disposal. And Norfolk Southern Corp. convinced investors to lend it $400 million for 100 years.

"When companies start putting out 100-year bonds, you can bet we've hit lows," says Richard Lehmann, a Miami money manager with $100 million under management. He has largely shunned investment grade corporate bonds. "This market has gone from stupid to ridiculous."

Stocks were the primary target of the Federal Reserve Chairman Ben Bernanke's attempt to push people out of Treasurys into riskier assets. But corporate IOUs that earn top grades from rating agencies have been on a tear, too — returning 31 percent in two years. That has allowed Corporate America to put trillions of dollars in their coffers and has sent billions of dollars to Wall Street banks who help them arrange the deals.

This has been good for the economy. But investors are another story.

"What happens when these securities return to normal valuations?" says Thomas Atteberry, who oversees the FPA New Income fund with $3.7 billion in assets. "It's not going to be a pretty picture."

The average investment grade corporate bond currently pays 3.73 percent in interest a year, barely more than the current rate of inflation, 3.2 percent. It's only the second time in two decades that the yield has fallen below 4 percent, according to Barclays Capital. If inflation rises, as many fear will be the outcome of current Fed policies, it will eat away at the buying power of the principal that is returned to bond holders upon maturity. That could turn winning bets into losing ones.

On first blush, Norfolk Southern bonds maturing in 100 years might seem to offer a good defense against the prospect of rising prices. Its bonds are paying 6 percent a year, well above inflation. But inflation can gyrate wildly. Prices have climbed as high as 18 percent annually in the past 100 years. Even at current inflation rates, cash stashed in a coffee jar would lose half its buying power in just 22 years.

Of course, the bigger question might be whether the railroad company will even be around in 2111 to pay anything back. A hundred years ago, the Austro-Hungarian Empire ruled over millions of people and investors held plenty of stock in Colorado Fuel & Iron. Gone are the empire and the stock. Colorado Fuel & Iron was a member of the most stable of Wall Street offerings — the Dow Jones Industrial Average. That is, before it went bankrupt.

"I wouldn't buy a hundred-year bond of anything," says David Sherman of Cohanzick Management, a money manager that is shorting investment grade bonds. "Nothing good can happen to you in that amount of time."

To be fair, many owners of so-called century bonds aren't human beings who won't live to see their money returned. They're pension funds and insurers with a good idea of how much they'll have to pay retirees and heirs in the future. Those groups want a predictable stream of income from bonds to make good on those commitments. Adding to the appeal of investment grade bonds: Regardless of maturity, they typically don't rise and fall in price as sharply as other assets like stocks. They also rarely default, delay interest payments or stop them altogether. As the recovery continues apace, companies issuing bonds defaulted on just 1.3 percent of what they've borrowed, according to Moody's Investors Service.

That could be good for investors if the market hadn't already reflected the lower defaults. In buying bonds, pros like to look at how much more they're getting paid in interest over what they'd get if they held Treasury bonds. The thinking is that U.S. government securities already reflect the possibility that inflation could eat into their return and so any additional interest that corporate bonds promise to pay is compensation for the risk that companies will fall on hard times and won't pay it at all.

That extra compensation stood at a little over half a percentage point last month, one of the stingiest offered in a quarter century. Even more unsettling, consider that the Federal Reserve has become the biggest buyer of Treasurys in its effort to drive interest rates down and revive the economy. It holds $1.4 trillion of them, more than triple what it held three years ago. To critics, Treasury prices and their rock-bottom yields reflect manipulated demand for them.

In other words, corporate bonds may be doubly overpriced — overpriced relative to something overpriced.

These bonds continue to attract money partly because many mutual funds that focus on bonds feel they must invest in them no matter what the price. No one can guess when bonds could tumble but if a fund sells them and they don't drop right away, it's sure to lose investors to rival funds that didn't sell and are still collecting interest and posting higher returns — for now.

"You have to dance until the music stops," says FPA's Atteberry, echoing a now infamous line from former Citigroup CEO Chuck Prince as to why he was making risky bets in the run-up to the financial crisis. "But if you look around the room, there's 20 people and one exit door. Not everyone is getting out."

How bad could things get in a rush to sell? Atteberry says if fearful investors suddenly demanded just a half percentage point more in yield to compensate for inflation, it would wipe out any gains for buyers at today's yields. If investors today received the kind of margin of error they normally demand, 10-year corporate bonds would be paying 7 percent a year — more than 3 points higher than they are now, he adds.

David Wright of Sierra Core Retirement Fund is just as critical of the almost willful ignorance of risk by investors. But he's buying. He says bears are ignoring the appeal of investment grade bonds as refuges of safety in the troubled times he sees ahead. Wright says investors are courting danger in myriad other assets such as stocks, which he thinks could fall as much as 35 percent over the next nine months.

"There'll be a shift from complacency to anxiety to fear," Wright says. "And they'll gradually move into these safe haven assets."

Or so they're called.