Corporate Bond Market Collapse Creates Opportunities

While the corporate bond market has collapsed, the 10-year Treasury yield has been range-bound between 3.5% and 4%. Despite the stock market crash and the widespread fears of a multi-year deflation, the T-note yield has been unable to penetrate this lower bound, which is perfectly understandable given estimates of a $1 trillion budget deficit in 2009. Whether funded through new supply or through Fed money printing, a deficit of this scope is bearish for longer-term Treasuries.

Remarkably, five-year inflation protected Treasuries (TIPs) are today yielding 2.57%, which is more than the 2.47% yield on nominal five year Treasury notes. This suggests that Treasury bond investors expect no CPI inflation over the next five years! This is a very grim outlook indeed, and one that reflects no faith in the ability of the Fed and the Treasury to generate positive inflation despite a long history of success.

Even more interesting than TIPs are the values available in corporate bonds, both investment-grade and high-yield. Junk bond yields and spreads to Treasuries have never been as high as they are today. Since the bond market risk reassessment (flight to quality) began in early June 2007, junk bond yields have spiked over 11%.

Junk bonds are currently priced to deliver double-digit, equity-like returns over a multi-year time horizon, even assuming default rates on par with the worst recessions. Another way to take advantage of record high corporate bond spreads, while reducing the degree of correlation with equities is to purchase investment-grade, rather than high-yield, corporate bonds. The most attractive ETF choices in this category are the iShares 1-3 Year Credit Fund (symbol: CSJ) and the iShares iBoxx Investment Grade Fund (symbol: LQD) - see table below.

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Comments

[Hedged In:]

This is a must-read article. Steinhilber is a cool head while others panic.

2008 Nov 11 03:52 PM

[Chris B:]

Market predictions of deflation can reverse in an instant, just as expectations of rampant inflation reversed last summer.

Consider this: The US consumer-led recession directly reduces the number of dollars received by the Chinese and others who buy our government debt. At the same time that our main debt buyers get fewer dollars, the budget deficit is exploding due to wars and bailouts. To sell its debts, will the govt have to offer higher interest rates?

2008 Nov 11 04:06 PM

[prairiedog555:]

The US, will inflate themselves out of this mess. Solves the housing market problem and pays back investors (in US debt) with inflated dollars.
There really is no other solution other than expanding this war into WW3.
This is a cycle, they can let it fester for years like the depression or inflate out of it and worry about inflation later.
Do you think that the Obama admin has the character and fortitude to let the market work itself out of this mess? I think not.
The Chairman, I mean President will take easy way out.

2008 Nov 12 07:27 AM

[300mph:]

Your chart contains old data. Many yields are lower than shown.

2008 Nov 12 12:06 PM