James Grant, always an astute and skeptical observer of the financial markets, write in no uncertain terms about the irrationality of current treasury yields in the Financial Times.
Here's part of what he has to say:
Insight: Return-free risk
By James Grant
Published: December 4 2008 17:39
US Treasuries are the investment asset of the year. The less they yield, the more their fans adore them. Then, again, these fearful days, yield seems to have nothing to do with investment calculation. Purported safety is all.
“Super-safe Treasuries”, the papers call these emissions of a government that, this year, will take in $2,500bn but spend $3,500bn. “Toxic assets” is how the same papers characterise orphaned mortgage-backed securities—or, for that matter, secured bank loans, convertible bonds, junk bonds or almost any other kind of debt obligation not bearing the US imprimatur.
“There are no bad bonds, only bad prices,” the traders used to say. They should say it again, only louder. In the spring of 1984, long-dated Treasuries went begging at yields of nearly 14 per cent in the context of an inflation rate of just 4 per cent. Those, too, were fearful times, the recollected horror being the great inflation of the 1970s. Inflation was ineradicable, the bondphobes said. Now a new generation of creditors espouses the opposite proposition. Deflation is baked in the cake, they say.
The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price.....
We can’t know, but we can at least observe. What I observe is a monumental push to reflate. The Federal Reserve is creating more credit in less time than it has ever done before – in the past three months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise no inflationary sweat?
Evidently, they are—at least, forward swap rates betray no such concern. The market’s best guess as to what the 10-year Treasury will yield in 10 years’ time is 2.78 per cent, never mind the famous (and now, as it seems, prophetic) remark of Fed Chairman Ben Bernanke that the Fed could drop dollars out of a helicopter in a deflationary pinch.
The non-Treasury departments of the credit markets have crashed. No surprise then that prices and values are deranged. Market makers have closed up shop for the year, while hedge funds cower in fear of redemptions. You’d suppose that professional investors – doughty seekers of value – would be combing through the debris for bargains. Alas, no. Most seem content to lend money to Henry Paulson (subsequently to Timothy Geithner) at 2 per cent or 3 per cent.
In corporate debt and mortgages, anomalies and non sequiturs abound.
.... Almost every day brings comparable examples of risks not borne by people who, in this time of crisis, have come to define risk as “anything not guaranteed by Uncle Sam”.
“Risk-free return” is the standard tag attached to the government’s solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description – “return-free risk”
The Economist recently made similar observations on the relationship between corporate bond yields and US treasuries.
An appetising spread
The chart at the top of the page shows 5 years of data for two ishares bond etfs: LQD the investment grade corporate bond etf (n red) and IEF the intermendiate term US treasury etf (in blue), both instruments have roughly the same duration. Bond prices move inversely to yield. In normal markets as can be seen in the chart throug late 2007 prices should move in the same direction with the differential between the price movements representing changes in credit spreads. Yet beginning in late 2007 anc accelerating this year one finds a radical divergence in price as treasury prices rally sharply (yields decline) while corporate bonds move in the opposite direction creating the large differential in yiess.
An irrational anomaly ? it seems so. Could it continue and infact increase ? History has told us that it can happen.
Nov 13th 2008
From The Economist print edition
The corporate-bond market is discounting very bad news
Illustration by S. Kambayashi
SHERLOCK HOLMES might have called it “the curious case of the corporate-bond market”. Most commentators agree that bonds issued by companies offer spreads over treasuries that more than compensate for the risk that the issuer might default. But few investors are tempted to buy.
The reason has more to do with the problems of investors than the deteriorating finances of issuers. About 20 years ago, the main buyers of corporate debt were pension funds and insurance companies. They would buy the bonds of creditworthy, investment-grade companies and then hold them till maturity. It made for a reliable-but-dull asset class.
The use of leverage, or borrowed money, changed that. All that hedge funds, and other speculative investors, needed to do was to buy bonds on yields greater than their cost of finance. The difference, or carry, would be the main source of return; if the bonds rose in price as well, so much the better.
Indeed, by early 2007 corporate-bond spreads were ridiculously low, offering a return that failed to compensate investors for the likely level of defaults. Borrowers rode roughshod over investors. ....
The market has now swung to the other extreme. According to Moody’s, a rating agency, investment-grade firms are now paying double the spread over government bonds that speculative, or junk, issuers were paying back in June 2007.
Junk issuers are now paying around 15 percentage points more than treasuries, compared with just two-and-a-half points in June last year. Investment-grade firms are now paying a spread of more than five percentage points, compared with less than one point in February 2007.
That might seem unsurprising, given the deteriorating economic outlook and the defaults we have already seen in the financial sector. But John Lonski, an economist at Moody’s, reckons that spreads are signalling the expectation of default levels not seen since the Depression. And Stephen Dulake of JPMorgan calculates that spreads are more than wide enough to compensate for the impact of a 2.5% fall in the American economy next year....
.....But the biggest question-mark is over those leveraged investors. Some hedge funds have been forced to sell bonds to raise cash so they can repay investors who are unhappy with their returns this year. Others have been forced to cut back because of restrictions imposed by their prime brokers, their main source of finance. And even those that are able to borrow money are finding it more expensive; Barclays Capital reckons that funding costs have risen by more than a percentage point since last year.
For such investors, corporate bonds may not be all that cheap once all the costs have been taken into account. In addition, there is always the risk that bond prices could fall (and spreads could widen) further in the short-term.
However, that still creates an opportunity for old-fashioned investors who do not rely on borrowed money and who can buy on the basis of a five-year time horizon. One such investor is Kathleen Gaffney, a portfolio manager at Loomis Sayles, a fund-management group. “We have moved beyond fear of financial Armageddon to thinking about the steps to recovery,” she says. But for the moment Ms Gaffney is the exception, not the rule.
The graph at the top of the page shows 5 years of data for two bond etfs. In red is the chart for IEF, the intermediate term treasuty etf. In blue is the investment grafe corporate bond etf LQD. Note that up until late 2007 the two instruments moved in tandem with the overall price level (price moves in the opposite direction of yield) with small movement in the price differentials reflecting the yield spread between the instruments. Yet beginning at end of 2007 and accelerating this year treasury prices have rallied sharply (yields falling) while the corporate bond prices have collapsed creating extreme values for differentials in yields between the two.
An irrational anomaly in the credit markets that will reverse at some point in the future ? it seems likely. Could this persist and even indrease ? quite possibly
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