Yield for Yield’s Sake: Picks and Pans

The rising chorus to short US Treasuries has picked up steam lately and for obvious reasons. Armed with sawed-off shotguns, global central banks have blasted double barrels of liquidity into the system, but the monster isn’t dead...yet.

Printing money seems to be the ammo of choice here in the US, but as we well know, our actions affect economies globally. It used to be that when we caught a cold, the rest of the world got pneumonia. Unfortunately, we have contracted a virulent strain of the Anglo Disease (a high-profitability disorder brought on by an unhealthy dominance of a western banking system). The rules of risk have changed and investors who understand these changes can avoid the cross-fire.

Euro-land: Germany’s failure to sell all their bonds during a recent auction caught a lot of people off-guard. Some feared that if an industrial nation like Germany couldn’t attract buyers, then maybe it could happen in the US Treasury markets too.

Anything is possible, but Germany has the unique burden of high labor costs relative to its GDP growth. Last July during the peak of oil prices, the ECB raised interest rates in an effort to ward off a wage price spiral after German labor unions demanded to be compensated for rising food and energy prices.

Although ECB chief Jean-Claude Trichet might have preferred to raise rates another notch, meddling by unions and a subsequent 2% decline in GDP growth there nixed that idea.

The German economy contracted in the second quarter and inflation slowed after record oil prices had declined.

Powerful labor unions have long dominated Germany’s industrial and service sectors. And, in the years following unification with the east, labor groups have enjoyed increasing political influence. Labor’s iron fist came at a cost though and they (the unions) have essentially priced themselves out of their own markets. With deflation in the mix now, high labor costs are even less competitive than before.

Mr. Trichet has vowed not to get trapped in a liquidity problem like ours, but as you can see in the chart above, the EU may be headed down that road. Until labor costs moderate to a level supported by GDP growth, there is no compelling reason to own Euro debt or Bunds.

The oil / dollar angle: This is a tricky one. So far, OPEC’s production “cuts” have failed to boost oil prices (currently about 73 percent below mid-July highs of almost $150). Port storage hubs here in the US are sloshing with inventory and there are tankers sitting in the Atlantic waiting to unload. Low oil prices may help to offset the import side of our trade-deficit balances, but a lack of demand here also spells trouble for our export markets.

Cheap oil is a bigger problem for countries producing it. Russia for example, has the world’s third largest foreign currency reserves. But, as you can see in the graph (aabove), the Russian Central bank has burned through a good chunk of its oil profits trying to stabilize the ruble.

Although Russia has made a quasi attempt to float the Ruble, it remains indexed to both the Euro and dollar. We would avoid Russia for now.

Venezuela is another country feeling the heat of plunging oil prices. Only one year after booting western oil companies out of the country, hot-head Hugo Chavez has been quietly courting several major oil companies to bid on new projects there. Such a shift in policy just goes to show how a global financial crisis can also hamper the socialist’s ideological agenda by demanding a pragmatic one.

Don’t forget about China: the Chinese are sitting on gobs of dollars and Treasuries which makes the China card an important one for two reasons:

• It’s no secret they want to trim exposure of their US currency and bond holdings.
• Slowing GDP growth in China has and will require some form of “stimulus.”

One option for the Chinese would be to pump some of their excess dollar reserves into their economy. Cost of this “capital” would be relatively low (courtesy of surplus trade receipts and Wal-Mart (WMT) shoppers) and it allows diversification away from the dollar.

China could also sell some of their US Treasury hoard, but they would likely do it discreetly. The Chinese might be nascent capitalists with a hidden agenda, but they’re quick studies of how markets operate.

Monetary policy is the bigger nut to crack. Back in July when oil prices were crazy, investors fled to the safety of long Treasuries as a 4.5% yield brought comfort to those yearning for safe harbor. You’d think investors would have realized that a 4.5% yield (then) hardly made up for inflation, let alone make a good investment.

Yet, six short months later, yields on the long bond scraped 2.5% and are sitting at about 3.25% now...one wild ride.

Interest rates will have to rise eventually, but the murky global picture makes it hard to know when. Meanwhile, yields are still low enough that you risk a chance of being smoked out of your hole.

Avoid being long US Treasuries: Financing trade deficits are one thing, but bailing out a screwed up western banking model-gone-bust is nuts! The shoes keep dropping, the price tag keeps rising, etc., etc. TARP: Treasuries Are Real Perilous!

One way we trade this uncertainty is via two inverse Treasury ETFs PST and TBT Inverse funds are volatile and we use them for trading vehicles only. But, it’s a good way to bet on rising rates without the hassle of buying individual futures contracts.

Consider corporate bonds: Another way to play a dysfunctional credit market is with corporate bonds. Yield spreads are wacky and poorly timed calls by the credit rating firms haven’t helped either, but we see some interesting opportunities for investors looking to bump up their income streams.

We look for companies able to service debt obligations with cash-flow generated by operations. In an environment like this, top-line growth is just frosting on the cake. Even the best managed companies report losses during a recession, but the better run organizations know how to survive without asking for a bone from the government.

Unlike Treasuries, corporate bonds aren’t backed by the faith of the US government. But, given the government’s bloated balance sheet, we’d prefer to take the risk of higher yields (now) and the potential for capital appreciation (later) over puny yields (now) and a chance of falling bond prices (later). Here are a few corporate bonds we like now.

W.R. Wrigley & Co. – Acquired by privately held Mars Inc. last year. Warren Buffett has a minority stake. Candy and chewing gum is a pure cash-flow business and family- owned Mars runs a tight ship. Take a look at the 4.65% notes due 2015 and 4.30% due 2010. Both are A+ rated.

Cytec Industries (CYT) – This specialty chemical maker is hurting along with the entire industry. However, Cytec is very well managed with a strong balance sheet and high level of earnings quality. We also like aggressive actions taken by management with the objective to improve net operating capital and increase cash-flow. Consider the 5.50% notes due 2010 or the 4.60% coupon due 2013. Rated BBB

What would Gomez Addams be buying in this market? Some of you may remember the kooky 60’s TV show The Addams Family with John Astin playing the role of eccentric billionaire Gomez Addams.

Astin’s character epitomized a happy go lucky capitalist with bubbling optimism, a short attention span and a childish glee when blowing up his model trains.

The show’s writers were way ahead of their time, but we’ve drummed up a list of 3^rd Party Trust Preferred securities that Gomez might consider a “capital idea”!

Disclosure: Author and/or his clients own MOT bonds and Comcast exchange traded debt.

Comments

[yellowhoard:]

The Fed seems to be committed to monetizing debt and holding down rates. Only god knows what the "real" rate on a 30 year bond is.

Feb 15 04:27 PM

[yellowhoard:]

Oh yeah! Gomez was also a big owner of Consolidated Sludge.

Feb 15 04:28 PM