The Federal Reserve responded to the financial crisis by dropping interest rates to zero (ZIRP) and by buying massive quantities of bonds and thus flooding the banks with newly created cash. We were told it would short lived. However, five plus years later it is still mostly with us because we are told that the economy is fine but only by a little. Therefore, faced with a banking system flush with cash and the average investor desperate for yield, there has been a multiyear rally in bonds. This rally was interrupted last spring but has since remained calm at marginally higher rates. While this calm lasts, it is important to review what are bonds, and what are bonds.
Bonds have a credit rating. The credit rating is based on the ability of the lending organization to repay the money lent to them. Standard and Poor is a leading bond rating service. Their ratings run from AAA to CCC or lower. AAA are the highest quality bonds. BBB and up are referred to as ‘investment grade’. Investment grade bonds have adequate to extremely strong capacity, depending on their rating, to both meet their dividend payments and return your capital. CCC’s are considered “vulnerable”.
Link to Standard and Poors
This is important because the recent years of yield chasing have dropped the yield on BB and lower bonds to record lows. In addition, these ‘junk’ bonds command a higher premium over their investment grade brothers. Investors rightly required a much higher dividend yield to compensate them for their higher risk. However, this premium is now near historic lows. This makes them vulnerable on two fronts. First, all bonds suffer a decline in current market price if interest rates rise. Second, their current market price will decline if the outlook for their financial stability worsens. So, you have to ask yourself; “Is the extra dividend yield worth the risk?”.
Link to the SF Fed
So there are bonds and there are bonds. It is important that you know which ones you own.