Key Points

  1. Rarely do intermediate and high-yield bonds look risky at the same time. However, it appears they are both risky today. Intermediate-term bonds are barely yielding more than short-term bonds, and “high-yield” bonds are not yielding much more than high quality bonds.
  2. Valuation conditions similar to today’s have only occurred twice in the past twenty years. Subsequent to both of those instances, intermediate-term and high-yield bonds performed poorly.
  3. This short paper explores why investors should be concerned about these risks and why we believe FPA New Income is well positioned to help investors navigate through them.

Fixed-income investors face potential subpar returns if they do not properly evaluate two aspects of risk: interest rate (or duration[1]) risk and credit risk.

Interest Rate Risk

Investors must take greater care not to underprice interest rate risk when short- and longer-term bonds have similar yields.

The following graph shows the spread in yields between the two- and ten-year Treasury bond (in blue) and what the market expects inflation to be (in green). The spread between the two- and ten-year Treasury bond is one way of measuring how worried investors are about future inflation and/or rising interest rates. Over the past twenty years, there have only been three instances when the spread has been this low: right before the 2001 and 2007-2009 recessions, and today.

Source: Federal Reserve Bank of St. Louis, Bloomberg.

The most logical reason why investors demand little or no extra yield to own longer-term bonds is if they expect a recession or another deflationary event. The problem is that deflation seems unlikely, as evidenced by the market’s growing inflation expectations.

Credit Risk

Investors must also be careful not to underprice credit risk when high-yield bonds do not have an adequate margin of safety[3] compared to investment-grade debt (including Treasuries).