Buying Bonds Now? Why We disagree...

EYE ON YIELDS: CORPORATE SPREADS
Half the story

“For risk averse investors, who can't stomach the ongoing volatility that the bottoming process in equities entails, a broadly spread investment grade bond fund offers upside exposure to an inevitable US recovery with limited downside risk.” Corporate Bonds: Discounting Depression, SeekingAlpha.com Dec. 19, 2008

“…we're talking about investment-grade corporate bonds, which are dirt-cheap right now… it's time to pounce.” The Case for Bonds, Fortune Dec. 22, 2008

“The bonds of high-quality firms normally yield one to two points more than the going rate of U.S. Treasuries to compensate you for added risk…. That's just too good to pass up, experts say”. The Bargain Bin, Money Jan. 2009

The pundit patrol has hit upon a new winning formula for ordinary investors: Buy Corporate bonds. The argument that these media anointed “experts” are espousing is that corporate paper is a lot cheaper than equities and will provide a lot more upside during a recovery period. This theory is based on the fact that the yield spread between investment grade paper and treasuries is at the highest level it has been since the depression.

The problem with this logic is that it does not account for the fact that corporate bonds have attractive yields on a RELATIVE basis. If benchmark rates were to rise significantly in the coming 12-36 months (which those of you who were on our call yesterday know that we anticipate) that spread could compress while overall nominal yields increase at a faster pace –leaving confused investors holding corporate bond funds that are down.

Advising retail investors to put on half a relative value spread makes about as much sense as telling them to put on half a merger-arbitrage stock spread, but in the rush for something to sell the talking heads are more than happy to do it.

To illustrate my point I have included two simple charts. The first shows How wide the spread between Corporate yields and treasuries has become on a relative basis, the second provides a longer term view of Fed Funds and CPI –with a focus on the late 70’s “Volker” era when rates rose dramatically as the Federal reserve fought a strong reflationary surge.

It doesn’t take a huge leap of logic to see the potential for reflationary pressure resulting from the current zero rate environment. Corporate bonds may indeed represent a good deal for some investors –but they deserve to see the whole picture instead of the half that the pundits are presenting.

Andrew Barber
Director, Macro

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