Understanding Bonds In This Market

Jul.18.06 | About: iShares 7-10 (IEF)

Roger Nusbaum submits: A reader quotes John Hussman and asks:

"Until we observe credit spreads widening, indicating a skittishness toward credit risk that would create a demand for safe government liabilities (cash and Treasury securities)..."

Roger could you clarify this? What then has to happen for being a bond bull? Sounds like something you have said before.

Credit spreads are important, sophisticated and tough to monitor directly. The yield of most fixed income products get compared to the yield of a US treasury of similar maturity. When the spread is relatively wide, the other security (maybe emerging market debt or corporate paper) is generally though to be cheap and when the spread is narrow the other security is thought to be expensive. This can also be viewed as a measure of risk. A narrow spread means that investors are accepting less yield for more risk. A problem with all of this is that most people cannot easily access yield info for these parts of the bond market. You can find info in articles but that is about it.

As far getting bullish or bearish or any other animal about the bond market, my thoughts have been fairly consistent. The curve is inverted with ten year treasury yields in the low fives. The low fives is historically kind of low, not crazy low but below normal.

The yield curve will get steep again, taking on a normal, positive slope. A positive sloping curve signals economic expansion as it makes lending money profitable for the banks. To normalize we need some combination of higher longer term rates and lower short term rates. I think a ten year treasury around 6.5%-7% toward the end of the decade makes sense.

Anyone buying a ten year treasury today and taking 5.12% would see their value drop if 6.5% pans out. As a rule of thumb, a 1% increase in rates equates to an 8% drop in prices. Obviously you get your money back at maturity but if you absolutely had to sell before maturity you might have to take a loss that offsets the interest earned.

Given that the Fed is about done, the two year treasury is unlikely to move a lot higher in yield. If you buy into the curve as predicting recession concept, than you might think the Fed could start lowering rates in 2007. If the Fed does start to lower, and I am not sure what I think about that just now, yields on two year treasuries would go down giving a chance for some, not a lot, price appreciation.

If two year yields go up from here, the potential 8% decline of a 1% move up in yields lessens because of how soon the two year treasury matures. At maturity the proceeds could be invested into higher yielding bonds, but with the ten year you would be stuck.

At some yield on the ten year it makes sense to back up the truck. A treasury yield that competes with the long term average for the stock market becomes compelling. In the early 1980s, treasury bonds yielded 15-ish%. Some people still own those. Think about that -- an asset that yielded 15% while the stock market was crashing at the beginning of this decade. We may never see 15% again, but we may get closer than you think.