Bonds Have Moved: Are Spreads Next?

Includes: BSV, HYG, IEF, SHY, TLT
by: Herb Morgan

Herb Morgan (Efficient Market Advisors, LLC) submits: This bond sell off did not come packaged as bond sell offs normally do, coinciding with a significant economic event or data metric. To some degree, this move complements two prominent opinion leaders, Goldman Sachs (NYSE:GS) and Merrill Lynch (MER).

Investors reacted with a slight anxiety attack and sold off bonds of longer maturities when Merrill’s David Rosenberg decided his early prediction, that a 90% chance of Fed Easing should be replaced with a 4% probability. Following right along Mr. Rosenberg’s call was Goldman’s team of Ed McElvey and Jan Hatzius, who opined that “we abandoned expectation of Fed Easing and we no longer anticipate any Fed rates cuts between now and the end of 2008”.

What I haven’t seen or heard much about is high yield spreads. If higher interest rates are poised to slow this economy, logic dictates that High Yield could take a double hit from higher rates and spread normalization.

High Yields Spread to Treasury

Historically investors could expect to receive 379 basis points over the risk free rate of treasuries when investing in high yield. Today that spread has narrowed to about 240 basis points. This is only partly due to the low absolute level of interest rates. More important to the analyses is that buyers of High Yield debt have bid up prices in expectation of a soft landing and possible Fed easing. While the level of overvaluation of High Yield is significant, it does not approach the level of excess valuation in the REIT market that I wrote about last week.

While I am thrilled that Barclays (NYSE:BCS) has recently launched a High Yield Bond ETF (NYSEARCA:HYG), investors would be wise to let credit spreads normalize before jumping in. For those looking for yield until then, I’d suggest avoiding the urge to yield grab and be content with Vanguard’s new short term bond ETF (NYSEARCA:BSV). It yields about 4.15% at today’s price, charges an .11% management fee and even has a little upside should the Fed unexpectedly ease sometime in the next several quarters.

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