Bond Market Still Reeling From Credit Crisis, Recession

Bond markets are not yet signaling that we are out of the woods in terms of the credit crisis and the broader economic recession. While there have been signs of improvement in the U.S. stock market since mid-July, action in the bond market has been characterized by increasing credit spreads (i.e. the yield premiums of risky bonds over Treasury bonds), which are at their widest levels since the credit crisis began a year ago, and renewed strength in Treasuries, which are at their lowest yields since the aftermath of the Bear Stearns (BS) implosion in March.

At current prices, Treasuries are an asset class with minimal upside and a significant amount of downside. Treasury yields are at very unattractive levels; there is a supply glut developing as the federal government deficit widens; and at some point the safe haven allure of Treasuries will diminish as the credit crisis and bear market run their course.

The only way Treasuries can continue to outperform is if a prolonged deflationary cycle takes hold, which we view as quite unlikely. A much more attractive alternative to a 10-year Treasury bond yielding 3.66% (9/6/08) is the iShares Lehman 1-3 Year Credit ETF (CSJ), which has a solid investment grade rating (single A), a 4% distribution yield, and minimal interest rate risk (1.9 years average duration). The 9.8% yield available from the SPDR Lehman High Yield ETF (JNK) is attractive on a relative basis, but conservative investors seeking income may want to wait to see if higher yields develop as defaults rise.

Historically, absolute yields in excess of 10% have been an effective threshold for the high yield asset class to be considered attractively valued and for investors to be adequately compensated for the risk inherent in junk bonds.