Bond-Market Blues: Where Did My Income Go?

The Federal Reserve building in Washington, D.C. ENLARGE
The Federal Reserve building in Washington, D.C. Photo: Andrew Harrer/Bloomberg News

If there is one area where low interest rates have propelled growth, it has been in the fixed-income market. But increasingly, income is the one thing that is hard to find.

For investors, that marks a further transformation in the fundamental characteristics of bonds, away from steady income to vehicles for capital gains. What investors should remember: this can also lead to capital losses.

The bond market has boomed in the wake of the financial crisis. Governments led the way, borrowing as budget deficits yawned wide; companies followed, first switching away from fickle bank financing and then lured by historically low rates to add debt to balance sheets.

The Barclays Global Aggregate, a broad investment-grade bond index, now contains over 16,900 securities with a face value of $ 39.8 trillion, up from $ 25.3 trillion at the end of 2007.

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But low rates mean bonds aren’t throwing off as much cash. Take the Global Treasury index of government bonds. In December 2007, it contained $ 11.9 trillion of securities, and in the year had generated $ 447 billion in coupons, according to Barclays data. By September 2015, its size had nearly doubled to $ 21 trillion of bonds, but coupons paid out in the past 12 months had crawled to only $ 535 billion. Low rates are providing a subsidy of hundreds of billions of dollars from lenders to borrowers.

Some of this is a desired consequence of monetary policy. And coupons aren’t everything—bondholders have seen big capital gains. But that means the market has simply extracted tomorrow’s value today as interest rates have fallen.

The problem now is how long ultraloose monetary policy has persisted: more and more low-coupon, long-dated debt has been and is being issued. If interest rates are permanently lower, that will change investor behavior.

Some might seek higher returns by taking on more credit risk; others might choose to buy longer-maturity bonds; still others might seek to leverage low-yielding bonds. But those exhibit bigger price swings, and that creates new risks.

The persistence of low rates is also changing the behavior of borrowers, who can load up on long-term debt at previously unimaginable rates. Companies are increasingly using this subsidy not for investment but to fund activities that can put bondholders at risk: mergers and share buybacks.

Some now think yields could yet grind lower: HSBC forecasts 10-year U.S. Treasury yields at 1.5% at the end of 2016, and 10-year bund yields at just 0.2%. If that happens, it will entrench these risks further, although extended monetary easing could delay the day of judgment.

Coupon-clipping might not be an exciting investment style, but over time coupon payments—and crucially, their reinvestment—matter. Their diminution distorts the bond market and creates a whole new kind of risk for investors.

Write to Richard Barley at [email protected]


WSJ.com: Markets

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