Wednesday, August 5, 2009

Too Good to be True?

Corporate Bonds have gotten quite a bit of ink lately.

Here’s a link from Reuters “Nonstop corporate bond rally raises eyebrows"”and the more sensational headline from Bloomberg "Junk Bonds Make Loomis Sense Dot-Com-Like Danger”. Take some time to read those links.
Don’t panic, yet.

Basically, the storyline is “Hey, look at this great rally we all missed”. Since we all missed it, it has to stop. It’s a bubble, help us!

Or something like that.

As a confessed bond junkie (bond junker?). I’ll admit that things have been good. Unexpectedly good. Historically good.

Not unlike the equity markets, the rebound of the bond market has been fast and furious. Perhaps even more furious than stocks. According to the Reuters article July was the first month in many in which stocks outperformed bonds.

Here’s a graph from the St. Louis fed showing the yields of Baa rated (Moody’s – think BBB for S&P).

Since prices move in the opposite direction as yields, prices have been shooting up as those yields have collapsed. The move in junkier bonds has been even more dramatic.

Which is good, but it’s also bad because unlike stocks (remember the dot coms), bond prices are bound by rational limits. A risky (non-treasury) bond should not trade a yield below the corresponding treasury of the same duration. And of course, it makes no sense to buy a bond with a negative yield.

Treasury yields have trended up, as evidenced by this nice graph of the US yield curve.

Bond yields collapsing, treasury yields rising, spreads (the premium over the treasury yield) falling .we’re in for trouble, right?

Not so fast. Here’s a practical example. Let’s say back at the end of April you decided to buy some Alcoa 6% July 2013 at 92.75%, to yield a solid yet unspectacular 8.2%. Not bad for 4 years and Alcoa isn’t an extreme risk (BBB-, just what they call “investment grade). Good for you.
Today that bond is trading around par (100%), yielding 6% to maturity and you’ve made more in a single quarter (9.4%....the 1.5% coupon plus the price appreciation of 7.8%), than you expected to make on average in a year of holding the bond. Time to take profits and move on, right?

Well sure…you can sell. And do what exactly with the money? Put in in CDs? You’re lucky to get 1% on a three-month CD and 3% on a 5-year one. Treasuries? 2.63% for 5 years.
Less yield, lower risk.

You could increase risk, moving down in credit quality or longer in duration, looking for a bigger payout. Higher yield, higher risk.

Or you can stay put, which makes a lot of sense. First of all, because 6% YTM ain’t bad for 4 years and second because ot the shape of that yield curve.

The yield curve is seriously inclined and looks to continue to be that way for a while, even if it does move around a bit. For argument’s sake, let’s say that Alcoa’s spread vs. treasuries remains the same a year from now (330 bps) and that the three yield treasury remains at 1.66%. The bond would yield about 5% and trade around 102.75%.

So…it nothing changes and you wait a year on the bond, you’re looking for 6% in interest and 2.75% in capital appreciation over the next year. 8.75%!!! Not bad.
Sure, things can move, but as of now 8.75% is your base scenario for the next 12 months, not 6%.

That’s how powerful that incline in the yield curve is.

So, yes…this may be the beginning of a bubble. And yes, it the market has run quickly and far. And yes…this is like a bargain basement, all the good stuff gets picked up first (and is gone now), so you have to rummage through the bins to find value.

But when the yield curve is like now, think of how much fun it is to “slide down” as if it were a water slide.

So for now, I’m still buying bonds, and selling the bubble story.

1 comment:

  1. Yeap! No longer a candy store, but let's digest the candies first!