Interest Rates are Headed – Where?

Investors Need to Ask About Return on What

Jun 3, 2009
Dean Lundell

Risk vs. Reward - Carlonte

The direction of interest rates on government bonds and all other types of debt over the prior two years have gone in opposite directions. Are you ready to commit?

Fixed-income investors should understand one simple concept; interest rate is a statement of risk – period. In more down to earth vernacular, there is no such thing as a free lunch. It is not enough to ask which direction interest rates headed. Rather, ask interest rates on what. The past two years has seen an historic dichotomy in interest rates between sovereign debt and everything else.

Credit Ratings are not All Inclusive

People that buy fixed-income investments need to know that credit ratings are not synonymous with each other. One needs to compare credit ratings within a particular group. For example, a AAA rating in the financial group does not mean the same thing as a AAA industrial. In addition to that, there are subtle differences between the various credit rating agencies, in that they do not share identical credit criteria.

In similar fashion, not all sovereign debt is created equal either. It would be ridiculous to say that third world debt ranks pari pasu with any of the developed countries and their economies. Also keep in mind that government agencies, such as in the United States, are generally subordinate to a country’s sovereign debt. There are certain certain agencies such as the Government National Mortgage Association that do enjoy a sovreign guarantee. Check on your own countries government agency status.

Interest Rates on What?

When the media reports that interest rates are moving in particular direction, they often neglect to say on what. Over the past couple of years, there has been a pronounced dichotomy between the interest rates on sovereign debt and corporate debt. According to the Merrill Lynch Corporate Master Index, spreads on investment grade corporate debt are approximately 560 basis points in the United States and 410 in Europe.

Spreads on "high yield" debt have also reached unprecedented levels. The Merrill Lynch U.S. High Yield Master Index II reports those spreads are almost 1,700 basis points. This is a clear indication of an economic recession but also of expected or anticipated credit defaults and credit rating downgrades.

Problem Areas

Research by Greenwich Associates confirms that there are a number of problem areas or issues that fixed-income investors should be aware of and that government regulators should address: Disclosure and transparency by dealers is a major concern, not only of pricing but research as well. Liquidity is also near the top as continued industry consolidation take place. Industry oversight by regulators is also a concern as is the consolidation of regulatory agencies.

Choosing a Dealer

Remember, the fixed-income market is dealer or over-the-counter market, not a broker market. Some criteria investors should look for in a dealer are that the dealer provides continuous liquidity and capital commitment. Investors have should expect a high level of service; just because the product is a commodity doesn’t mean the level of service is. Make sure of the credit worthiness of your dealer is good and that the dealer has an ongoing commitment to research.