Bonds Have Moved: Are Spreads Next?

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 (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.

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 (BCS) has recently launched a High Yield Bond ETF (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 (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.

Comments

[Long-Short Guy:]

Another ingredient:
<blockquote>
<b>Treasuries Attract Pension Funds Overflowing With Stock Gains</b>

Treasuries are getting an unexpected boost from pension funds controlling more than $14 trillion.

Fund managers for companies including General Motors Corp. and Alcatel-Lucent are shifting away from stocks to prepare for accounting changes requiring them to more fully disclose the value of their holdings. Bonds are gaining favor as funds seek to avoid wider swings in prices that may accompany equities as the new rules take effect, possibly later this year.

The switch couldn't come at a better time for the $4.4 trillion market for U.S. government bonds, which hasn't returned more than 3.5 percent a year since 2002...
</blockquote>

Source:
www.bloomberg.com/apps...;sid=aCoF9B9h8rxs

2007 Jul 23 01:41 AM

[Long-Short Guy:]

Also interesting:
<blockquote>
<b>U.S. notes look primed to extend price gains on housing data</b>

Reports due out this week are forecast by economists to show that sales of new and existing U.S. homes declined last month, and that news may extend a two-week gain in prices of U.S. Treasury notes, the biggest rise in more than three years.

...Last week, prices of Treasury securities rose the most in more than four months on increased speculation that losses in notes backed by subprime mortgage loans might curb U.S. growth. The Federal Reserve chairman, Ben Bernanke, testified before the U.S. Congress that inflation would recede and that housing market weakness could slow the economy.
</blockquote>

Source:
iht.com/articles/2007/...

2007 Jul 23 04:05 AM