"Bonds - Is The End of Their Rally in Sight?"

Sydney M. Williams

Thought of the Day

“Bonds – Is The End of their Rally in Sight?”

April 13, 2010

As investor despair deepens, the rush to safety intensifies. As despair dissipates, investors reverse course and assume more risk. This has been our experience over the past two years. 2008, which will be long remembered as the year credit markets collapsed, 2009 as the year of redemption. As problems intensified, Treasuries rose in price, with the yield on the Ten-Year declining form 4.04% to 2.24% over the course of 2008. During that year, the yield on the Bloomberg-FINRA Index High Yield Bonds rose from 10.45% to 17.43%. The S&P 500 was down 38.5%. It is the behavior of investors that can be seen in these numbers.

The nadir of the 2008 crisis occurred between Sunday, September 7 when the government took control of Fannie Mae and Freddie Mac and Monday, October 13 when revisions to TARP prompted a huge intraday rally – the DJIA rose 11.08%. On Friday October 10 the TED Spread (the spread between 3-month LIBOR and 3-month T-Bills) widened to 460 basis points, versus a pre-crisis level of around 50 basis points. (Today that spread is 12 basis points.) It is unsurprising, then, that the U.S. Treasuries along with gold and the Dollar were the only asset categories to enjoy gains in 2008.

Investor preferences reversed in 2009. In fact, investor’s behavior, mirrored in markets, had already begun to change in the final weeks of 2008. On November 18 of that year, in my TOTD, I wrote that LIBOR was “261 basis points lower than it had been on October 10th.” Corporate bonds, both Investment Grade and High-Yield, troughed in November of 2008 and actually showed positive returns for the 4th Quarter of 2008. In contrast, all stock indices continued to decline and, as we all know, did so until March 9. Despite money still flowing to Treasuries, the natural forces of a willingness to increase risk was already apparent in the corporate bond market. Markets had already assumed that the credit crisis was being resolved and we were left dealing with its aftermath – a severe recession, typically a deflationary event.

2009 saw the Ten-Year Treasury decline in price, as the yield rose from 2.24% to 3.84%. Gold continued to rally, but the Dollar fell. The positive trend in corporate bonds continued throughout the year, so that by the end of 2009 Investment Grade Corporates, at 5.07%, were yielding less than they had been before the crisis began in July 2007. Today, the spread between Investment Grade Corporates, at 105 basis points, is less than it was on June 30, 2007, a remarkable turn of events and an indicator of a willingness to assume more risk. Investment Grade Bonds have continued to rally into 2010, yesterday yielding 4.88%. As well, and even more dramatically, High-Yield Corporates rallied in 2009 with the yield declining from 17.43% at the end of 2008 to 9.57% at the end of 2009 and 8.46% today, below the yield of 8.51% these bonds sold at on June 30, 2007.

The rise in bond prices has been accompanied by strong flows into bond mutual funds and ETFs. (Stock mutual funds, in contrast, experienced outflows throughout 2009 and have only turned positive in the past two months.)

A corollary of the decline in yields has been an improvement in corporate balance sheets. The improvement in balance sheets, obviously, has more to do with reductions in employment, increases in outsourcing and enhancements to technology, but every bit helps. Zach Karabell, former President of Fred Alger and President of River Twice Research, points out in a recent piece in the Wall Street Journal that corporate balance sheets have about $2 trillion in cash – funds that could be used for, among other purposes, mergers and acquisitions. Reflecting this improvement in balance sheets, along with better than expected earnings, investors continue to extend out the risk continuum. Stocks have rallied 79% since the March 2009 lows, but they remain, unlike their bond cousins, 20% below their June 30, 2007 level; in fact, the S&P 500 is still 5% below where it was when Lehman filed for bankruptcy.

There are two ways to make money in bonds. One, you simply collect and reinvest the coupon, hoping that inflation remains below the interest rate level to provide a reasonable return. Second, one can make a bet that inflation will decline and the price of the bond will appreciate, giving the owner a capital gain along with the coupon. In a deflationary environment, secured bonds will provide attractive returns, though one must be particularly wary of credit risk as deflation and recession are often bed partners.

In the first quarter of 2010, domestic general stock funds outperformed general bond funds by a factor of almost two to one. Yet flows into bond mutual funds were more than double the level into stock funds. It suggests to me that, going forward, flows into stock funds are likely to exceed those going into bond funds. This is not an argument to suggest stocks are cheap, but only that they look more reasonably priced than bonds, especially those companies with attractive balance sheets and with the prospect of increasing dividends.

Bonds become less attractive, as Bill Gross makes clear in his April “Investment Outlook”, during periods of rising rates and ultimately higher inflation. The conundrum for investors is that draconian reductions in government spending may be necessary in order to reduce deficits that threaten to choke growth. The last time we went through such a period was in the early 1980s when the Federal Reserve, with the compliance of the Reagan administration, induced a recession by raising rates dramatically in order to kill inflation. The question becomes, does the current administration have the will to reduce spending in such a forceful manner to bring fiscal sanity back to Washington? Given the insatiable appetite to spend, it is difficult to answer in the affirmative.