S i z i n g Up R i s k i n t h e B o n d Ma r k e t

Bonds and Their Valuation

© JOHN

CLARK/SHUTTERSTOCK

7

CHAPTER

194

Many people view Treasury securities as a lack-

luster but ultra-safe investment. From a default

standpoint, Treasuries are indeed our safest

investments; but their prices can still decline in

any given year if interest rates increase. This is

especially true for long-term bonds, which lost

nearly 9% in 1999. However, bonds can perform

well—in fact, they outgained stocks in 5 of the

8 years between 2000 and 2007.

All bonds aren’t alike, and they don’t neces-

sarily all move in the same direction. For exam-

ple, corporate bonds are callable and they can

default, whereas Treasury bonds are not exposed

to these risks. This results in higher nominal

yields on corporates, but the spread between

corporate and Treasury yields differs widely

depending on the risk of the particular corporate

bond. Moreover, yield spreads vary substantially

over time, especially for lower-rated securities.

For example, as information about WorldCom’s

deteriorating condition began coming out in

2002, the spread on its 5-year bonds jumped

from 1.67% to over 20% in mid-2002. These

bonds subsequently defaulted, so greedy people

who bought them expecting a high return

ended up with a large loss.

When the economy is strong, corporate bonds

generally produce higher returns than Treasuries—

their promised returns are higher, and most make

their promised payments because few go into

default. However, when the economy weakens,

concerns about defaults rise, which leads to

declines in corporate bond prices. For example,

from the beginning of 2000 to the end of 2002, a

sluggish economy and a string of accounting

scandals led to some major corporate defaults,

which worried investors. All corporate bond prices

then declined relative to Treasuries, and the result

was an increase in yield spreads. As the economy

rebounded in 2003, yield spreads declined to their

former levels, which resulted in good gains in cor-

porate bond prices. The situation is once again

worrisome in 2008. The subprime mortgage crisis

has led to fears of recession; and this has caused

spreads to rise dramatically, especially for lower-

rated bonds. For example, the spread on junk