Speculative-Grade Winning Streak Continues

High-yield, speculative-grade credits outperformed higher quality investment-grade credits once again in July, extending their winning streak to five months.

Not only that, but within the high-yield market itself the riskier “Caa” component is simply trouncing the overall high-yield index (average credit quality is B1) and it is doing so by a fairly wide margin as our data box below illustrates.

For high quality Treasuries, however, it has been a long tough stretch. Treasury prices remained under pressure with the U.S. Treasury index just managing to eke out a positive return for July on the final day of the month. While investors’ increased risk appetite (“the flight from quality”) is the primary cause, the size of the new issue calendar is not helping too much either.

I have discussed in the past the record size of the Treasury auctions and here I find myself referring to them again. During the last week of the month, the Treasury auctioned off another $115 billion in new debt consisting of $42B in 2-year maturities, $39B in 5-year maturities, $28B in 7-year maturities, and $6B in a re-opening of the 20-year TIPS issue. There was plenty of discussion over the “success” of the 5-year auction to boot.

Also on the calendar for early August is a new round of auctions for 3, 10 and 30-year Treasury debt. Finding enough buyers of our nation’s debt to support the massive costs of our various “economic recovery” programs remains a critical issue.

Another question one might ask is how we intend to pay it all back. As a firm we are not necessarily negative on the dollar right now, as it is already cheap versus most other developed country currencies.

However it is easy to see the “appeal” of a weak dollar when we do eventually have to pay back that debt. If we borrow $1 today, and the dollar then weakens by 25%, we could find ourselves having to pay back only 75¢. This is not a forecast – just an observation about one possible outcome.

The yield on the 10-year Treasury fell from 3.53% to 3.48% in July, resulting in a total return of 0.48% -- just the second positive month for that benchmark bond so far this year. Its year-to-date total return is -8.3%.

Overall, Treasury yields remain very low. You would have to go out to the 2-year before you can even get 1%. Nevertheless, while the flight to quality that began last year now appears over, there are still some investors who can’t live with any (credit) risk. For them, these levels may not be rewarding, but a guaranteed positive return no matter how low, is still easier for some to take.

A client recently asked me about our comfort level with the future inflation “predicted” by the break-even rate on Treasury Inflation Protected Securities (TIPS). For example, on July 31^st, the 10-year “nominal” Treasury yielded 3.48%, while the 10-year inflation-linked TIPS bond yielded only 1.70%. The difference between the yields of 1.78% is the rate of inflation over the next 10 years that would equalize the returns of the two bonds (break-even inflation rate or BEI). If inflation is higher than 1.78%, the TIPS investor comes out ahead. If inflation turns out to be lower than 1.78%, you would have been better off with a nominal 10-year Treasury. The income from TIPS rises (and falls) with the rate of inflation in the Consumer Price Index (CPI) as their principal value is adjusted by that rate.

I don’t think of TIPS as actually predicting the rate of inflation - that is something left for the economists to do. Rather, I view the BEI level on TIPS as something that investors can respond to based on whether or not they believe inflation will be higher or lower. The difficulty is that the BEI is forward looking, while CPI looks back on actual inflation.

Using monthly data over the past ten years, inflation expectations have averaged 2.03%, while core CPI (excluding food and energy) has averaged 2.18%. Pretty close, but that may be just coincidental. I do believe that in the early years TIPS were less reliable as inflation barometers than they are today. Early on, the TIPS market was much smaller, less liquid, and more volatile than it is today. However, in the absence of anything else, I believe the break-even rate on TIPS -- based on a real market where real money is put up – is a reasonable guide for investors to form the basis of their decision making when it comes to inflation.

We continue to be proponents of having inflation protection for client portfolios and the TIPS market is a high quality way to obtain that exposure.

Comments

[phillips49]

Why I bought "junk" and still own it.

It boils down to risk/reward.

All investing is speculative. Last year proved it very painfully. The market suddenly collasped from under all asset classes with the credit market freezeup, giant liquidation sale and rapid leveragaging of the investment markets. Money moved into "safe" investments. Treasuries became over bought and yields dropped to zero as investors just tried to keep what they had. At that point even treasuries became a risk ,since they would have to eventually unwind as well as fear faded.
The current yield on"safe" 5 year bonds is 2.49%. I use 5 year since that is the maturity of the junk I own. Junk pays 800 basis points more. The yield has held up remarkably well through the financial crisis. The default rate fears have not materialized. So cash money is paid every month. "cash", real money in the till! And it comes monthly, not quarterly or semi-annually.
As financial markets stablized and some confidence returned and the underlying value "NAV" has also increased by 25% showing some confidence in the unlaying assets.
I suspect that with the tightening of lending standards, companies can ill afford to default on bonds. Who will buy a bond from a company that has a history of default. Who will lend a company money with a poor credit record. Bond holders also have quite a significant say, even in bankruptcy. To wit the role of GM bondholders.

Inflation is not a short term concern.

The stock market is a little ahead of itself at the moment anticipating the end of the recession. Earnings have been achieved by cost cutting to which there is a limit. Growth has not been demonstrated, just hoped for. So in my view it would be a bad time to jump in..downside risk. Treasuries at this point also have more downside risk that upside potential.
Junk may still have some upside potential left. I use September 1 2008 as a benchmark for fair price on these assets. So if the market goes down, I still get 10-13% cash every month. If the market goes up I get the cash and the increase in NAV as well.

Everything is all about debt at the moment, so why not invest in it? You don't have to worry about P/E, new product lines, competition or the cost of goods. Debt is owed money. Pay it back!

I suspect that since bonds performed better than stocks in the last decade, that the baby boomers are now moving into fixed income as they approach retirement.

Of course there is always cash, but then again no pain, no gain.

2009 Aug 16 03:05 PM

[Old Trader]

"The default rate fears have not materialized".

I'd append a "yet" to that, and not get too comfortable. A good comment, all in all...you've obviously given a lot of thought to the position.

2009 Aug 17 08:50 PM