All That Glitters / Are Bottom-crawling Interest Rates Inflating Corporate Bonds?

Stocks continue to astonish with their northward march, but the real drama these days is in the bond market. Barely a day passes without excitement in that sphere. For example, let's look at last week. Just last week

? On Thursday, 10-year U.S. treasury notes plunged to a price reflecting a yield of 4%, for the first time since October 2008. It was the sharpest drop in price since 2003. Russia, which owns $138 billion worth of American government bonds, declared that it may move its investments into another kind of bond, issued by the International Monetary Fund.

? China owns $768 billion worth of U.S. government bonds and says it's thinking of buying $50 billion worth of IMF bonds.

? The rising yield increases interest rates on all kinds of credit. Interest on 30-year mortgages in the United States shot up from 4.85% in April to 5.74%.

? Not everybody is boycotting American debt, of course. On Friday, Japan's finance minister said his country's faith in U.S. bonds cannot be shaken. The result was that an $11-billion American bond offering, which the markets were closely watching, went well. Among the clients buying the bonds were apparently central banks in Asia.

The entire market rose, lifting 10-year treasury notes back to prices reflecting yield levels of 3.79%. "The market reached levels at which Asian institutions showed some interest," said a Barclays Bank analyst after the successful Friday offering.

And now, economists and policy makers are quaking in their boots about something else entirely: that rising yields on bonds is imperiling the very global economic rebound. They are afraid that the shy green buds of recovery could be blasted.

Since bond prices have been falling because of fear of a future glut, as Washington finances its gargantuan deficit, all eyes have been glued on its recent issuance.

The question everybody's asking is: Has the U.S. Federal Reserve Board lost its ability to control long-term interest rates? Judging by the directions in trading these last few days, evidently a lot of people think that's a "yes."

A safe harbor in Israel

In Israel's bond market, the atmosphere is a lot less charged. But the relative peace may be misleading, costing investors a pretty penny in a lot of different areas.

The corporate bonds is one such area. To recap, in the fall of 2008, corporate bonds - including those of established companies - plummeted to lows never seen before. The level was so low that it reflected expectations that half Israel's companies going broke. The average yield on the Tel Bond-20 index was 8.2% in mid-November, about double the yield on comparable government bonds then.

Since then, the appetite for risk has returned and the bonds have recovered all their lost ground. The average yield on the Tel Bond-20 index today is 4%, and the spread between them and comparable Israeli government bonds is 1.7%.

How did that happen? Simple: The bottom-crawling interest rates forced investors to seek places offering potential returns that weren't downright insulting.

Returns on bank deposits and short-term certificates (makams) were basically zero. Returns on linked government bonds were negative. Stocks started to look less risky after having lost half their value (quite a few pros anticipate a downward correction there). What's left? Corporate bonds.

Risk premiums have nowhere to drop

But are they safe? Bond yields consist of two main components. One is basic yield, derived from the yield on government bonds. The other is the extra yield, derived from the risk inherent in the company. It compensates for the risk of not meeting its liabilities.

Both these components are in danger these days.

If yields on American bonds continue to rise, yields on Israeli government bonds will, too, and therefore, so will the basis by which corporate bonds are priced.

What about the risk premium? That's also hard to quantify. But after the risk premium investors demand fell from 4% to 1.7%, it probably can't fall any further without returning to the credit-bubble levels that characterized the period before the crisis erupted. And after all, the economic situation hasn't staged a complete comeback yet.

The bottom line is that corporate bonds have rallied impressively, more than any other investment avenue in Israel, even more than stocks.

Nobody's talking about bailing out the tycoons any more and several companies, good and less good, are planning bond offerings. Because of the bottom-crawling yields on other investment avenues, speculative money is going into bonds.

But just like on the eve of the crisis, this is the time to remind ourselves: Corporate bonds are not risk-free. Any further increase in yields in America, or drop in the level of economic optimism, will hit their prices.