Bond Market: Unsafe at Any Yield?

This year will be remembered for many things, most of them negative, brutish and just plain ugly. But 2008 will likely to go into the history books for other reasons, including a year that extended extraordinary gifts to strategic-minded investors. No less extraordinary will be the dearth of investors willing or able to accept the gifts from the financial gods.

So it goes in the money game. When prospective returns --l ong-run prospective returns -- are thin, the crowd can't get enough. At the other extreme, when risk premia is soaring, Mr. Market finds few takers. All the more so when fears of depression are swirling about.

Consider the chart below, which is but one example of the astonishing repricing of risk now underway in the bond market. The recent spread in junk bonds over Treasuries is currently at levels last seen, well, almost never, at least since the modern notion of high yield bonds as an asset class was minted in the 1980s. Today, the asset class can be had at a yield spread of nearly 1,700 basis points over a 10-year Treasury yield. For reasons that need no explanation, there are few takers, which is one factor for why the spread's so high. By comparison, in June 2007, the spread was compressed at one point to less than 260 basis points, to which investors were happily accepting.

There are, of course, many reasons for shunning such rich spreads, just as there were many reasons for accepting the narrow spreads in June 2007. Indeed, juicy yields invariably come prepackaged with economic contraction and higher rates of defaults in the junk bond universe. They don't call 'em junk for nothing.

Are yields now sufficiently high to compensate for the higher level of defaults that are surely coming? No one really knows, although that doesn't stop anyone from considering the broader context. On that note, junk bond guru Martin of Fridson Investment Advisors in New York told Bloomberg News on Wednesday: "Either the [high-yield bond] market is right and expecting a default rate considerably higher than it was in the Great Depression, or we have such profound dislocations and selling pressures going on that it really is creating extraordinary fundamental value.''

Yes, the spread may go higher still, perhaps much higher. At some point it'll stop going up and it's a near certainty that almost no one will be buying at that apex. Indeed, few are buying now, and the buyers will surely dwindle further in the weeks and months ahead. That's not entirely illogical, since some of us like to get a decent sleep each night.

This much, however, is clear: Several years from now, when we all look back on 2008, many of us will promise to buy if junk spreads ever go that high again. The lesson being: Great bargains only look compelling in a rear-view mirror and talk is cheap.

Comments

[Smarty_Pants:]

Even at these spreads the junk bonds are barely beating inflation. Why risk possible default for that? Hard assets will likely fare better over the next several years and the risk of default is minimal.

2008 Nov 21 11:36 AM

[JasonC:]

"Inflation" is running at a -11.3% annual rate.

2008 Nov 21 12:30 PM

[Moon Kil Woong:]

Who wants to tie up their money now when they have their own debt to worry about. In essence most all consumers are walking junk bonds.

2008 Nov 21 12:40 PM

[Owen:]

Good article, and a brilliant title, James! Most here are probably too young to be familiar with Nader's original.

2008 Nov 21 02:36 PM

[zanardm:]

One more bubble to go?

The American economy has already had an enormous stimulus package, called the hugh (50%) drop in energy gasoline) prices. The result: no change in general economic activity, although transportation of goods, commuter confidence, and core inflation, benefit. Stimulus package (politician code word for more debt) is obviously not the solution; rather it is the problem. the private sector is deleveraging, but not the public (federal) sector). Do the polies have only one note - more debt? How come they never use the debt word? Get ready for one long slog. Bubbles Law: in a deleveraging environment, all bubbbles must deflate. Watch out treasuries, supply and demand will eventually crater the debt market and the polies. Creditor 's economic vote in the marketplace does count; part of Adam Smith's invisible hand. Command and control does not work economically nor politically.

2008 Nov 21 03:17 PM

[bricki:]

Hard assets go down in a deflationary environment. My mother owns two farms that my grandfather bought for $200 in the Great Depression.

Right now cash is king as everyone tries to liquidate as fast as possible in the greatest selling panic since 1929. Like my grandfather I'm keeping my powder dry to buy when the price is right.

2008 Nov 21 03:18 PM

[bobomite:]

The US will never escape the debt spiral it is in with a private central bank.

If the Treasury loaned money to the "Federal" Reserve and collected interest the situation would reverse.

Otherwise, the debt will climb forever.

2008 Nov 21 03:26 PM

[k45:]

Junk ratings are defined by the ratings services (Moody's, S&P) which have been proven extremely untrustworthy. The market pricing is interesting. GE Capital bonds, rated AAA are selling a yields 200+ basis points over AA Walmart bonds, etc. Financial bonds are getting higher yields but most of us don't trust the ratings.

2008 Nov 22 08:56 AM

[zanardm:]

The yield curve has behaved reasonably; the VIX is on. But supply will certainly increase this and next yr - 2 trillion plus budget deficit? Creditors, both domestic and international are unpredictable, in such an extreme deleveraging environment. How extreme? Not seen all the way back to 50's. Next stop - 30's. Where perhaps nothing actually worked; a long deleveraging period is required, both for actual debt, and for deleveraging in our brains. Of course the latter does not apply to politicians - who are hopeless. '... stimulus package' just more debt. Debt is not the solution; rather it is the problem; theprivate sector is dealing with it. Not so for the public federal level, where the solution is always the same - more spending (debt), another stimulus package. As mentioned, the 50% drop in gas prices (stimulus package, but without more debt), didn't change any economic numbers; consistent with the importance of time and reducing debt. The reasonable yield curve (temptation for gov borrowing -why not), and TIPs - no inflation in sight for 10 yrs perhaps, is another indicator of the severity of what we are in; none of us have experienced this extreme situation. Of course the drop in gas and other commodity prices, also evidence for severity of downturn. Again it's the future of the treasuries market, which I find disturbing. One seems to more easily come up with negative scenarios than positive just so scenarios. Politicians can make the prolonged deleveraging situation worse, but they can't make it better. Gridlock for DC is good - less debt. 'we must have patience' Kutazov in War and Peace.

2008 Nov 23 01:08 AM

[zanardm:]

p.s. could one have a marked decrease in demand for treasuries, with minimal antecedent yield curve changes, due to extreme deleveraging environment? Can a stampeed in treasuries occur very rapidly, and unannounced? Was Freddie Max and Fannie Mae sudden decrease in demand by creditors a precedent and harbinger of future events?

2008 Nov 23 01:20 AM

[zanardm:]

On Nov 23 01:20 AM zanardm wrote:

> p.s. could one have a marked decrease in demand for treasuries, with
> minimal antecedent yield curve changes, due to extreme deleveraging
> environment? Can a stampeed in treasuries occur very rapidly, and
> unannounced? Was Freddie Max and Fannie Mae sudden decrease in demand
> by creditors a precedent and harbinger of future events?

Might Oct 2008, beginning of 2009-2010 fiscal year, and the rumor of a coming 3-4 trillion deficit, be a critical time for the treasury market? IF it becomes increasingly clear that the politicians have only more debt (stimulus) to offer as there only card, how might the Invisible Hand of creditors respond?

2008 Nov 23 02:43 AM

[Fabien Hug:]

What is best now, junk bond or junk stock? In general, I think you are better of with a junk bond for the portion of your assets you want to allocate to financial instruments. Interest and redemption must be paid and the potential upside in price is a big as for the stock. Now if you choose the wrong company, the risk is the same as the stock.

2008 Nov 23 09:50 AM