The name is bond and the outlook is very risky

THE membranes of global government, corporate, junk and emerging market bond bubbles are now dangerously thin. Two key pointers in the past week indicate that these securities have become very risky for institutions and individuals.

The first warning was a sudden sell-off of US Treasuries on the mere hint that some US Federal Reserve Board members believe that the central bank should stop buying bonds at some stage this year.

The second warning shot was that average yields of high risk so called "junk" corporate bonds fell to a record low of 5.89 per cent, a spread of only 400 basis points above US government bonds. This illustrates that some advisors, traders and investors have thrown caution to the wind and are risking money on over-borrowed, poor performing companies that could default on their debt if business conditions worsen.

Investors have become sanguine about the interest rate risk of an unexpected upward lurch in bond yields central banks have been buying government bonds to keep both short and long term interest rates at minimal levels.

These purchases have underpinned US Treasury, German, Dutch, French and UK government bond prices in the past year. Central banks, however, can only keep bond yields down if economies remain depressed and the market expects the era of low yields to continue indefinitely.

The chart showing that bond yields have fallen to their lowest levels in more than 200 years, however, illustrates that instead of safe havens, even the top quality government and corporate bonds are no longer safe haven investments.

Despite efforts of central banks to manipulate rates downwards, market forces can drive bond yields upwards.

According to some estimates, total bond holdings in the US amount to some US$37 trillion (S$46 trillion), and if bond investors become nervous, they can easily turn sellers, they say.

Indeed market forces have already pulled yields up from their 2012 lows. Ten year US bond yields bottomed around 1.43 per cent last year and have since risen to 1.9 per cent. When bond yields rise, the price of bonds fall and the longer the life of the bond, the greater the price depreciation. Thus those investors who purchased Treasuries at 1.43 per cent have incurred a loss of 4.5 per cent, and for those who bought thirty-year treasuries at 2.45 per cent, compared with current yields of 3.1 per cent, the capital loss is 6 per cent.

At current levels, US Treasuries are still overvalued as the real inflation adjusted return is virtually non existent, warn economists. US inflation was 1.8 per cent in November 2012 and was well over 2 per cent earlier in the year. If the economy revives next year, money continues to shift into equities and perceptions of higher inflation become the norm, US treasury yields could continue to rise.

Moreover, foreign investors who are wary of the Fed's dollar devaluation policy may decide to sell, causing a further upward lurch in yields.

Investors have been attracted to corporate bonds because yields, especially low quality junk securities, are higher than those of government bonds. Such has been the rush that some advisors have brushed aside the credit risk and the relative poor marketability of the issues compared to high volume blue chip shares.

Equity investor in sound companies see profits and dividends rise over the long term. The best that a corporate bond holder can hope for is a reasonable yield and the hope of price appreciation if the general level of interest rates decline.

For junk and some emerging market bonds, the prospect, following a boom in the securities in the past year and current historically low relative yields, is lose-lose, analysts warn. Rising US Treasury bond yields normally bring in their wake an increase in corporate bond yields and capital losses. On the other hand, if there is a recession, junk and emerging market bond credit risks soar and investors may attempt to sell in a thin market. Moreover, withdrawals from bond and exchange-traded funds can cause dumping of relatively illiquid bonds.

The Bank For International Settlements (BIS) has issued a stern admonition to fund managers, bankers and brokers who are advising investment in junk bonds. In its latest quarterly report, the BIS warns that "corporate bond yields fell to their lowest levels since before the 2008 financial crisis" but "appeared highly valued in a historical context relative to indicators of their riskiness."

For example, global high-yield corporate bond spreads have fallen to levels comparable to those of late 2007, but the default rate on these bonds is around 3 per cent, compared with 1 per cent in late 2007. The risk is not being compensated for.