Bonds are More Attractive Than Stocks for Now

We’ve been mostly in cash since July and are searching for a good time and place to recommit to risk assets. Bonds seem a better beginning than stocks. We’ve committed about 1/3 of our target bond allocation during November.

PIMCO has been saying for a while that investors need to be high in the capital structure in these perilous times — meaning quality bonds. Bill Gross re-emphasized that point in his December letter, where he pointed out that the deleveraging of stocks, government intervention and investment in operating companies, and other factors change the rules and the future for stocks — making bonds a better place to be for now.

We share that general view, but we are also concerned that the money supply expansion through rescue programs by the US and other governments sets bonds up for problems down the road due to inflation and interest rate increases. How long down the road we don’t know.

Sept. 9 (Bloomberg) — The cost of hedging against losses on Treasuries rose to a record on concern the U.S. government faces higher liabilities because of its rescue of mortgage companies Fannie Mae and Freddie Mac, credit-default swaps show. … Contracts on U.S. government debt increased 3.5 basis points to a record 18, up from 6 basis points in April … for five-year credit-default swaps … Credit-default swaps on German government bonds cost 8 basis points and Japanese bonds 16.5 basis points.

Stocks may recover sooner and farther than bonds, but bonds may become less risky sooner and to a greater degree than stocks.

We think risk management comes first, and then striving for return, but within acceptable risk parameters. For that reason we are more comfortable putting cash to work in bonds than in stocks at this time.

We still hold and intend to hold substantial cash, but we are putting some money into bonds.

Our cash is held in Treasury money funds that have punishingly low yields, but are protected by the federal value guarantee of money fund assets prior to September 19th. We are considering moving to general money funds for yield, but have not yet made that decision. We’ll probably make that decision sometime in January.

“Bonds” is as broad a topic as “stocks”. They aren’t all the same and need to be viewed categorically. Here are charts comparing the price movements over the past 12 months for a variety of funds by bond type.

[click images to enlarge]

US Aggregate Bond ETF vs Various Bond Type ETFs

AGG, TLT, SHY, HYG, LQD, MUB

Only Treasuries are in positive territory. Muni’s and aggregate bonds are close in price movement. Investment grade corporates are down, but high yield bonds are devastated.

The situation is mixed and fluid. Europe and the US bond risks are deteriorating, while Asian bond risks are improving, according to investors who price those risks with credit default swaps.

Dec. 3 (Bloomberg) — The cost of protecting corporate debt from default jumped to a record in Europe and neared a high in the U.S. amid concern that the global recession will sink into a depression. … Credit-default swaps on a benchmark index tied to below- investment grade companies in Europe reached levels considered distressed for the first time. The cost to protect U.S. leveraged loans from default neared a record … Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should borrowers fail to adhere to their debt agreements. An increase indicates deterioration in the perception of credit quality; a decline signals the opposite.

Dec. 3 (Bloomberg) — The cost of protecting Asian bonds from default declined after the U.S. Federal Reserve extended the term of three emergency-loan programs in a bid to ease the global credit crisis.

US Aggregate Bond Mutual Fund vs Various Bond Type Mutual Funds

VBMFX, VWEHX, VCVSX, VFIIX, VBIIX

Convertible bonds are more battered than high yield bonds, yet they have a somewhat lower credit risk rating (Ba2) versus corporate high yield bonds (Ba3) — both of which are below investment grade.

The SEC 30-day yield on the convertibles is 4.95% versus 13.68% on the high yield bonds. The two funds have similar duration (3.8 and 4.2 years respectively).

Presumably, convertibles have sunk further more due to reduction or elimination of the conversion premium than for reduced credit worthiness. Note, however, that this convertible fund, and most likely others, have about 3/4 allocated to the financial sector. In this case, the balance is about equally split between healthcare and telecom.

Moody’s Rating Scale

It is important to note that the credit rating agencies are not held in highest repute these days. They are being questioned by the US Congress and European authorities and will probably be regulated as a result of their obvious failures to properly rate mortgage related securities. We note also that they rated Lehman as investment grade until only a few days before it filed for bankruptcy. Pay attention to their ratings, but do not assume that they are absolutely correct.

US Aggregate Bonds ETF vs Treasury ETFs by Maturity

AGG, TLT, SHY, TLH, [[IEF], IEI SHV

Treasuries are strong, but perhaps too strong. When risk appetites come back, investors will probably rotate to riskier assets such as other bond types or stocks. That would tend to drive the down the price of Treasuries.

What the Fed’s intention to “buy” Treasuries to support the market will do as a counter balance to downward forces is not knowable. Since they will use IOU’s (effectively print money) to “buy” Treasuries, they have unlimited capacity to buy versus the market, which has finite capacity to buy, because non-central bank actors have to use real money and have other rational and practical limits.

US Aggregate Bonds Mutual Fund vs Various Muni Type Funds

VBMFX, VWALX, VWLUX, VWIUX, VMLUX,VWSUX

All the the muni funds here have blended portfolios rated AA by Moody’s. The longer the duration, the worse the recent price peformance. The market has penalized longer dated muni’s more than longer dated Treasuries. That is probably a credit risk factor more than a time value of money factor — otherwise the shape of the Treasury and muni charts by duration would more closely resemble one another.

Note that while the muni funds in question are AMT-free, they do have substantial revenue bond holdings versus general obligation holdings. For example, the 2-6 year fund has somewhat more than 50% revenue bonds which may be quite senstive to the economy and are not guaranteed by full faith and credit as are general obligation bonds.

National Muni Mutual Fund vs Selected Single State Muni Funds

VWLTX, VWAHX, VPAIX, VOHIX, VNYTX, VNJTX, VMATX, VFLTX, VCITX

Understandably, high yield muni’s are at the bottom of price returns. That fund is a reasonableness check against California which protests that it is running out of cash.

California is the worst performer among the selected single state muni funds. Florida is second worst. The northeast state muni funds are the strongest, and stronger than the national muni fund. Presumably, the national fund is dragged down by the bulk of California bonds and Florida bonds in the overall portfolio (#1 CA 14.5% and #5 FL 5.8%).

Coda:

We think owning bonds is a reasonable place to be for the risk portion of a portfolio at the moment, but we are alert to possible changes of circumstance and condition as the economy and government policies take their twists and turns before the world becomes a bit more “normal”.

Bonds are likely to have larger allocations in many portfolios in the next few years, or at least until the next stock mania. For that reason, we think more investors should become acquainted with bonds and bond matters than has be the case in the recent past.

Comments

[Larry House:]

Very useful article. Thanks for the analysis. Bonds in general appear quite attractive now, but on the other hand, they seem to be about as precarious as stocks. A huge unknown is how all the corporate refinancing will go over the next couple of years. I think that will keep pressure on junk bonds for quite a while. Yields are at all-time highs, but default rates are sure to climb in this environment--how high they will climb is a big question mark. High quality bonds appear to be the best choice even if yields are more muted, but even the soundness of GE is being questioned with their debt load. Utmost caution, short commitments, and lots of cash seems the best way to go for now. Thanks again for a very good article.

2008 Dec 04 10:13 AM

[Walter1234:]

Good article Richard. Do you think looming state/city budget crises will result in any muni defaults.. Thanks, Walter.

2008 Dec 04 10:29 AM

[Phiota:]

Muni Bonds looks good if you think the federal government will bail them out otherwise not so good.

John

2008 Dec 05 04:51 AM

[mauldin0495:]

muni bond good? with revenue shortcomming and uncontroled spending. possible muni default increase. muni bond good? what is muni bond yield at now?

2008 Dec 05 08:20 PM