The Bond Market's Message

The sharp rise in Treasury bond yields at the same time as corporate bond yields have plunged reflects declining risk spreads, even as a surge in inflation is not a serious concern.

Moreover, corporate bond yields have fallen sharply enough that businesses are aggressively locking in financing at very low yields. And such rates are now low enough that bonds are no longer particularly attractive relative to stocks.

The rise in yields on Treasuries is a very favorable development. Yields on 10-year Treasuries would have remained near their 2% low only if investors remained more focused on the safety of their capital than on the return on their capital. So, those unsustainable low yields are gone and that’s clear evidence of substantial improvement in financial market conditions.

This is the reason why the Fed felt no need to increase its buying program of Treasuries to push those rates back down.

Significantly, while Treasury yields increased, corporate bond yields fell. That also signals that investors are more comfortable taking on some risk and credit conditions are normalizing.

Even so, the credit crisis was so traumatic for corporate financial officers that they are issuing new bonds and renegotiating credit lines at a rapid clip, even when outstanding bond issues or credit lines do not mature in the near term. They just don’t want to take any chances with their companies. Many have agreed to pay a percentage point or two more to extend the maturity of their bank lines by a few years.

This is very good for bank profitability, but it also spares CFOs of their worst nightmare that they may have a bond mature in a dysfunctional credit market. So, they are financing aggressively while they can. Bond yields have fallen sharply, more than seems warranted by a comparison to stocks.

An outstanding article by Michael Santoli in the latest edition of Barron’s demonstrates that the yield on the common shares of several major companies exceeds the yield on their bonds. As Santoli correctly points out, either the bond yields are too low or the stock prices are too low. Some reaction is likely from both sides, with the eventual adjustment pushing up both bond yields and stock prices.

Indeed, it is becoming harder to find reasonable bond yields (relative to inflation) without accepting increased default risk in the junk bond arena. By inference then, stocks are the better value by far. The path may not be smooth, but stocks should end the year higher, as incoming economic data supports the turnaround thesis for the economy.

Comments

[Alphameister:]

Thank you for another very insightful commentary on an issue of great importance to investors. We seem destined to live in a troubled economic environment for a long time, but it is good to see continued normalization taking place and risks being reduced accordingly.

Jun 30 09:13 AM

[johnbee:]

Would you rather have your money in a single currency or Gov bond
than in an international trading company of years standing? Yields will go up and bonds down while solid companies you can still buy at a 40% discount to last year will continue trading.

Jun 30 10:16 AM

[MarkitWacha:]

Fear is going back into the market. Bonds are correcting with yields going down.

I think that people will rush into bonds in cycles over the next 5 years due to the coming 2nd wave of mortgage resets (2012) and bank failures. The question is whether the Fed will relax and put some necessary reflation into the economy before that wave hits.

Jun 30 12:33 PM

[whidbey:]

" So, those unsustainable low yields are gone and that’s clear evidence of substantial improvement in financial market conditions." Or speculation, or another miscalculation by the bond market. Or something worse:

Look at this months Forbes and read the man who says that Bonds are the best play for the future. What say you Charles?

Jun 30 02:43 PM

[CLH:]

For the long term stocks are the best buy because they are cheap. Bonds cant go up in price any more so in the long run they are a poor buy.

Check the 1930s. Bonds went down in price until 1982 which was the best time to buy bonds in history.

Jul 01 07:40 AM

[Randy Durig:]

You can get your Government bond quotes at:
investment-income.net/...

Jul 10 11:11 PM