Why Investors Keep Buying Expensive Bonds

road sign to bond market
By Leslie Shaffer

It's pretty clear bonds are a bad job, with returns relatively meager and prices likely to fall ahead, but yield-seeking investors keep pushing money their way. "People have been buying bonds for some years and going further out the risk spectrum to get yield as Treasury yields fall," said Mark Matthews, head of research for Asia at Julius Baer. Bond yields move inversely to their prices. "There's not a lot of value left in fixed income in general, not just the high yield," he said.

"With the Federal Reserve tapering [its asset purchases] and looking to raise rates next year, the price appreciation we've seen generally over the last five years [will reverse] and prices will fall as yields head up," Matthews said.

That hasn't stopped investors from chasing bonds' payouts. So far this year, $56.69 billion has flowed into bond funds, outpacing the $44.06 billion heading into equities, according to data from Jefferies.

All those funds chasing what appear to be ever-smaller yields have kept bonds expensive and sometimes crowded.

"Investment grade credit is trading rich and looks increasingly vulnerable to rising rates," Morgan Stanley (MS) said in a note last week. "Upside appears very limited in high yield, and a negative shock [emerging market turmoil, weaker China or domestic growth etc.] is possible."

Others are concerned about the move further out the yield spectrum.

"The yields that you're getting over government bonds have reduced dramatically. We're not at record-tight levels but we're not that far away," Steve Goldman, managing director at Kapstream Capital, a fixed income fund manager with $7 billion under management, told CNBC last week.

%VIRTUAL-article-sponsoredlinks%"What it's meant that investors are moving toward greater and greater risk in order to pick up slightly higher yields. And you've got to be careful because the quality of the issuance in that high yield or junk space is going down," he added.

Just how much risk are investors chasing? The International Finance Corp., a World Bank unit, is getting ready to offer local-currency bonds in Rwanda next month. The Rwanda offering will likely be well received, if the reception of the IFC's first offering under its Pan-Africa note program is anything to go by. That issue -- of 150 million Zambian kwacha ($24 million) notes in September -- was 4.8 times oversubscribed, according to a Bloomberg report.

Rwanda raised $400 million in a 10-year Eurobond bond offering last year, with the yield on the notes due 2023 falling to around 6.7 percent this year. By way of comparison, India's 10-year government bonds due in 2023 are yielding around 8.9 percent.

Even the seemingly "safe" U.S. Treasury segment is seeing some risk chasing. Barclays is advising seeking out "off-the-run" Treasurys, or bonds and notes issued before the most recent paper, to squeeze out around 30-56 basis points of extra yield -- even though the off-the-run bonds are much less liquid.

"We are comfortable taking some additional liquidity risk to pick up spread," Barclays said in a note last week.

To be sure, not many expect a bond crackup anytime soon.

"A downturn in the current credit cycle seems unlikely and the coupon income of high yield is hard to find elsewhere," the Morgan Stanley note said.

Others point to data from Moody's indicating corporate issuers don't seem to be running into any walls just yet.

"There has not been an increase in the default rate," Julius Baer's Matthews noted. "Cash levels at corporate America are at an all-time high," he said. "The credit metrics are still very robust in the high-yield market. That's why people are still very happy to stay there, even if you don't get paid very much."

Richard Harris, CEO at Port Shelter Investment Management agrees that problems at the corporate end don't appear likely, but he's a bit more cautious on sovereign bonds.

'Toughen Up or Die'

"The last few years, corporates have had to toughen up or die," he said. "When interest rates go up, and they will eventually, it's a lot less likely to impact the corporate sector than it is the government sector," he said.

As the eurozone debt crisis has settled down, investors have plowed into peripheral Europe's debt, but "it doesn't mean to say dangers are any less," Harris said, noting the size of interest payments due from the periphery this year alone. The PIIGS, or Portugal, Ireland, Italy, Greece and Spain, will pay some 130 billion euros in interest this year alone, according to calculations from the Financial Times.

Yield chasing has led to anomalies in European bonds, such as still-worrisome Spain recently selling five-year government bonds at nearly the same yield as their U.S. Treasury equivalent. The yield for five-year Spanish debt was around 1.68 percent as of Wednesday morning; U.S. Treasurys were around 1.68 percent.

This month, Greece also issued its first long-term bond in four years, with the five-year security attracting 20 billion euros worth of bids. Greece sold around 3 billion euros worth of debt at an around 4.95 percent yield.

"We're likely to see people focus on the growth aspects, rather than the debt aspects," he said, but added "it's still a fragile situation. The overall economy [of Europe] looks good, but that because Germany looks extremely good."

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Why Investors Keep Buying Expensive Bonds
"Your daily habits and routines are the reason you got into this mess," writes Trent Hamm, founder of TheSimpleDollar.com. "Spend some time thinking about how you spend money each day, each week and each month." Do you really need your daily latte? Can you bring your lunch to work instead of buying it four times a week? Ask yourself: What can I change without sacrificing my lifestyle too much? 
Remove all credit cards from your wallet and leave them at home when you go shopping, advises WiseBread contributor Sabah Karimi. “Even if you earn cash back or other rewards with credit card purchases, stop spending with your credit cards until you have your finances under control,” she writes.
If you do a lot of online shopping at one retailer, you may have stored your credit card information on the site to make the checkout process easier. But that also makes it easier to charge items you don't need. So clear that information. "If you’re paying for a recurring service, use a debit card issued from a major credit card service linked to your checking account," Hamm writes.  
Reward yourself when you reach debt payoff goals. "The only way to completely pay off your credit card debt is to keep at it, and to do that, you must keep yourself motivated," Bakke writes. Just make sure to reward yourself within reason. For example, instead of a weeklong vacation, plan a weekend camping trip. "If you aim to reduce your credit card debt from $10,000 to $5,000 in two months," Bakke writes, "give yourself more than a pat on the back." 
“Establish a budget,” writes Money Crashers contributor David Bakke. “If you don't scale back your spending, you'll dig yourself into a deeper hole." You can use personal finance tools like Mint.com, or make your own Excel spreadsheet that includes your monthly income and expenses. Then scrutinize those budget categories to see where you can cut costs.    
Sort your credit card interest rates from highest to lowest, then tackle the card with the highest rate first. "By paying off the balance with the highest interest first, you increase your payment on the credit card with the highest annual percentage rate while continuing to make the minimum payment on the rest of your credit cards," writes Mint.com spokeswoman Hitha Prabhakar.
To make a dent in your debt, you need to pay more than the minimum balance on your credit card statements each month. "Paying the minimum -– usually 2 to 3 percent of the outstanding balance -– only prolongs a debt payoff strategy," Prabhakar writes. "Strengthen your commitment to pay everything off by making weekly, instead of monthly, payments." Or if your minimum payment is $100, try doubling it and paying off $200 or more. 
If you have a high-interest card with a balance that you’re confident you can pay off in a few months, Hamm recommends moving the debt to a card that offers a zero-interest balance transfer. "You’ll need to pay off the debt before the balance transfer expires, or else you’re often hit with a much higher interest rate," he warns. "If you do it carefully, you can save hundreds on interest this way."
Have any birthday gifts or old wedding presents collecting dust in your closet? Look for items you can sell on eBay or Craigslist. "Do some research to make sure you list these items at a fair and reasonable price," Karimi writes. “Take quality photos, and write an attention-grabbing headline and description to sell the item as quickly as possible." Any profits from sales should go toward your debt. 
If you receive a job bonus around the holidays or during the year, allocate that money toward your debt payoff plan. "Avoid the temptation to spend that bonus on a vacation or other luxury purchase," Karimi writes. It’s more important to fix your financial situation than own the latest designer bag.
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