Usually, six months into a period of aggressive rate cutting by the Federal Reserve, higher risk/higher return assets begin to outperform – or certainly hold their own versus – lower-paying, creditworthy U.S. Treasuries (although past performance does not guarantee future results). This only makes sense as falling short-term rates help the economy by lowering borrowing costs for many consumers and corporations, expand the nation’s money supply as well as reduce the attractiveness of income investments closely-indexed to falling short-term Treasury rates such as T-bills, money markets and bank certificates of deposit.
Since last September, the Fed has reduced its key lending rate a staggering 57% or 300 basis points to 2.25%. In addition, policymakers have provided hundreds of billions in standby lending facilities for large se-curities dealers (normally, only banks can borrow directly from the Fed) should they need more capital to run their businesses.
Despite this massive liquidity infusion into the financial system and reassurances from voting members such as William Poole of the Saint Louis Fed that the U.S. will probably avert a recession, uneasiness approaching near panic continues to dominate sentiment in the bond market.
In particular, investors are concerned about the health of the nation’s banking system. As the recent implosion and subsequent government-orchestrated bailout of Bear Stearns illustrated, a significant amount of nonperforming loans are tying up capital at our nation’s banks and financial institutions and this lack of credit is severely restricting lending to individuals and businesses, negatively impacting sectors outside of housing and making economic predictions even more difficult than normal.
All this uncertainty, of course, has resulted in a gut-wrenching “flight-to-safety” in the bond market. Treasur-ies have delivered the best total returns year-to-date (between 3% and 6.25% depending on maturity) while spreads – the yield advantage over benchmark Treasuries – on risk assets such as corporate and mortgage backed debt have widened to five-year highs (pressuring prices lower) on fears of increasing defaults. The fact 3-month T-bill rates have plunged to 50-year lows of 0.60% reinforces how intent investors are about preserving capital and unsure of future credit conditions despite historic liquidity infusions by the Federal Reserve.
The Bond Market Will Tell Us When Credit Conditions Are Improving
Because of the complexity, severity and uniqueness of the mortgage and housing problems, predicting how the credit crisis plays out and the timing on a recovery is impossible. Unlike previous market downturns where retail investors primarily got hurt the most, many so-called sophisticated investors - from well-respected individual investors to the ratings agencies to Fed policymakers themselves - underestimated the severity of the credit crisis and in retrospect, made some very poor decisions.
During the first half and through the summer of last year, we had been cautious on the economy and unlike many of our peers, felt the Federal Reserve would need to reduce rates to negotiate a soft landing. We gave policymakers the benefit of the doubt when they noted as late as November problems in the subprime mortgage arena were contained with some voters actually questioning the need for aggressive easing! As it turns out, the Fed underestimated the severity of the fallout and subsequent downturn and in turn, so did we.
It’s pretty apparent there’s no quick fix to a credit crisis some economists are calling the worst since the Great Depression. Obviously, the longer it plays out, the more damage to the economy. However, because the financial markets reflect investor expectations about future (not current) business conditions, signs the credit crisis is moderating will likely surface on Wall Street before they appear on Main Street. Among the real-time market indicators we’ll be monitoring (and what to look for) include: equity prices of financials (likely to coincide with declin-ing bad loan writedowns by banks); corporate bond spreads (the risk premium on investment grade and high yield corporates have surged since January on default fears – these spreads need to start narrowing); primary issuance (a pickup in new debt deals would indicate some investors and lenders are becoming more confident in the economy and that liquidity is gradually returning to the bond market) and finally, Treasury rates (rising intermediate and longer term government bond yields would be another positive sign as it would suggest some investors believe the worst of the credit crisis has passed and higher risk/higher returns assets will outperform government debt going forward.
Fed Rate Cuts And “Flight to Safety” In Treasury Sector Combining To Create Problems For Savers
As helpful as declining market rates are for our heavily-financed based economy and consumers, they create challenges for savers and total return investors. With benchmark government bond yields approaching multi-decade lows (10-year Treasury rates currently stand at 3.35%, just 28 basis points above the 50-year low), we see little value in extending maturities when the Fed is aggressively printing money and consumer inflation is running at the upper end of the Fed’s comfort zone (2.5+% annualized).
The fact rates on money market instruments have dropped significantly as the Fed has reduced short-term rates and now stand well below longer term market rates has understandably increased the allure of more volatile higher-paying, longer term investment grade bonds and preferreds. Believing the majority of the Fed’s easing is done and policymakers will take back recent rate cuts when the economy starts to recover (they’ve said so much), we’d limit the maturities on any new purchases of fixed rate, investment grade corporate and municipal bonds as well as agency debt to five years and less. Again, the longer the maturity on a bond, the greater the potential volatility when long term rates change. For example, a 100 basis point increase in long term Treasuries would translate to about a 15 point paper loss and negatively impact closely-indexed higher quality corporate, municipal and agency debt.
Unfortunately, such a defensive strategy means sacrificing some current income but we think more conservative bond buyers will have a much better opportunity to lock in higher yields at some point in the future. Given all the money that’s sought refuge in the Treasury market over the last six months, the selloff in rate-sensitive securities, when it does occur, could be significant. In fact, investors with undue exposure to long term interest rates - holding long-term, higher quality bonds – should consider reducing their holdings and repositioning more defensively. Obviously, investors who disagree with us and believe the economy is headed for protracted recession should continue to extend maturities with new purchases and/or hold more rate-sensitive longer term bonds.
Our Favorite Income Ideas Include CDs, Munis and Selected High Yield Corporates
Given our lack of confidence in longer term investment grade bonds now, where are the best values for maturing assets and/or cash? Any recommendation, of course, depends on one’s investment profile. For safety-conscious investors, we continue to recommend FDIC-insured CDs. CDs are paying considerably higher returns than money markets and Treasuries. Based on our bearish outlook on Treasuries, we’d keep maturities to two years and less. We’re very active in CDs on a daily basis, so don’t hesitate to contact us for the latest rates from around the country.
As we discussed in last month’s Income Investing, municipal bonds are offering attractive after tax returns for in-vestors in the higher tax brackets. Because income paid on munis is free of federal tax and usually state tax in the state where the bond was issued, their yields are almost always less than Treasuries. However, concerns about the viability of certain bond insurers, dislocations in the auction rate preferred process and forced liquidations from leveraged funds have resulted in higher quality municipal bonds yielding more than benchmark governments. Again, we’d limit the maturities on any new purchases to five years and less.
Last but not least, we’re starting to see some intriguing total return opportunities surface in the beaten-up high yield corporate bond sector. Take for example the debt of Harrah’s Entertainment, the world’s largest gaming/hotel operator. The company was purchased by a group of private equity firms for about $17 billion ($11 billion in new debt and $6 billion in equity) late last year. The bonds are down about 30 points - trading in the 60’s to yield 15% - on fears the company will be unable to service its increased debt load. We think some investors are underestimating the talents of Harrah’s well-respected management team and substantial asset base (50+ casinos operating under marque names such as Bally’s, Caesars and Harrah’s). Because of the deep discount in price and double-digit yield, this bond is suitable for more aggressive total returners only.
Although the information included in this report has been obtained from sources we believe to be reliable, we do not guarantee its accuracy or completeness. This report is for informational purposes only and not intended as an offer or solicitation to purchase or sell any securities. Sources used to compile this report include barrons.com, Bloomberg, bondmarkets.com, investinginbonds.com, newyorktimes.com, realmoney.com, USA Today, valubond.com, Wall Street Journal and wikipedia.com. More complete information is available upon request. Yields and price information as of 3-21-08. Peter Conroy - Bond Trading Desk - JP Turner & Company LLC.
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