Are Corporate and Muni Bonds a Safe Haven?

With the stock markets seesawing their way out of the public’s comfort zone since the dramatic declines of 2008-2009, many investors have turned to the “safety” and “security” of bonds for piece of mind.

Is that piece of mind warranted?

We don’t think so.

In early May of this year we read in the Financial Times that prices of US junk bonds, as measured by the Bank of America Merrill Lynch index, had rallied closer to par than at any time since June, 2007.

Readers will note that was prior to the most damaging waves of the credit crisis.

And in the 26 June edition of the Wall Street Journal, an article titled Muni Bonds: Don’t Hit the Panic Button Yet shed some additional light on this latest trend, which has seen more and more investors opt for fixed income investments of every stripe.

In the deflationary environment that we expect over the next few years, cash and income will be the keys to financial survival. Readers of this column may want to peruse our earlier commentaries on the subject of deflation and why we believe it is the primary trend in the years ahead, but in a deflation cash and income streams are king.

It therefore not only makes perfect sense to seek out safe and secure additional revenue streams wherever they may be found, but it is also highly advisable during a period in time where job security has become a thing of the past, accumulating dust on the closet shelf alongside punk rock and Big Hair.

But the question, a key question to be sure, is whether investors are being lulled once again into a false sense of security by placing their faith in debt instruments that may not hold up during what are very likely to be many years of continued strains in the global economy.

It is these strains - the deleveraging and fiscal conservatism that goes hand in hand with deflationary times - that will apply immense pressure on corporations as well as states and municipalities, since they all are reliant on, and looking to, an ailing consumer for his dwindling number of spending and tax dollars.

During the inflationary years of the stock and real estate booms, investing in most debt instruments provided a double whammy of sorts, which saw not only regular coupon payments but also capital appreciation, as liquidity circled the globe looking for yield with barely a concern raised to the issue of creditworthiness.

During inflationary booms when asset prices across the spectrum are rising, one can get away with throwing caution to the wind. Until the music stops, that is.

In our opinion the music stopped two years ago and today the trend is deflationary, which means there is a very different dynamic at play. Credit quality becomes important again during deflation, where the return of one’s capital, and not merely a return on capital, should be the single most important factor in the investment decision.

However, discerning credit quality is not an easy thing, and deferring to others, such as a broker or rating agency, may not be the wisest decision either. History is littered, particularly recent history, with bad investment decisions at the worst moments in time and equally atrocious results from the ratings agencies.

Many an investor has been burned over the years reaching for yield, or the perceived security of a bond. For those with a crystal ball, and reasonable certainty that a particular debtor will remain standing on the other side of this drama, it might make perfect sense and be highly rewarding to lend that debtor your money.

For the rest of us, in light of the perilous state much of the western world finds itself in today, not least of which are dangerously high debt levels that may never be repaid, it might make the most sense to stand aside for a while in cash and the shortest maturity treasury bills, until some sense of sanity and clarity returns to the markets.

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