With returns on Treasuries remaining low, investors are beginning to discover the fat yield spreads to be found in corporate junk bonds
With yields on longer-dated Treasury securities on the rise since the start of 2009, there's been some debate about how the Federal Reserve should proceed if it wants to keep interest rates capped in order to free up more credit to individuals and small businesses. On Jan. 28, the Federal Open Market Committee, the central bank's policy-making arm, voted to maintain the target range for the Fed funds rate at zero to 0.25% and said it wouldn't purchase Treasuries at this time.
From one perspective, the implications of higher Treasury yields for homeowners seeking to refinance adjustable-rate mortgages at affordable fixed rates and other cash-strapped consumers and business owners shouldn't matter much. After all, it was the Fed's announcement that it would buy up to $500 billion in mortgage-backed securities that pushed mortgage rates substantially lower after they failed to drop in concert with falling Treasury rates.
For investors, on the other hand, Treasury yields can't rise fast enough. The prospect of yields staying relatively tame for the foreseeable future has investors already looking for alternative places to place their cash.
Ideas as to what's behind the uptick in Treasury yields—and the drop in prices—vary depending on who you speak with. Some fixed-income managers see it as a simple matter of supply and demand, with $70 billion worth of two- and five-year notes to be auctioned this week and an estimated $66 billion in three-, 10-, and 30-year securities to be offered the second week of February, according to The Wall Street Journal.
Others view the bounce in yields over the past month or so as a correction to an overdone rally in Treasury prices in the final weeks of 2008, when investors, spooked by the apparent freefall across a range of asset classes, fled to the relative safety of government debt. "It shows from a reflationary standpoint you're getting some confidence that the Fed and the rest of the federal government will be able to keep us out of a depression," says Jamie Jackson, portfolio manager for fixed income at Riversource Investments (AMP) in Minneapolis.
To David Glocke, a principal and portfolio manager at the Vanguard Group in Valley Forge, Pa., however, all bets on an economic recovery in 2009 and possibly even 2010 are premature.
Frozen Credit Flows
The global recession is serious and won't easily be fixed, despite the growing size of the stimulus package the Obama Administration is throwing at it, says Glocke. He cites the possibility that the unemployment rate will reach 10% as endemic of recessionary conditions that would imply interest rates will stay low for an extended period of time. Much of the government stimulus money already released through TARP hasn't flowed through to individuals and small businesses. People aren't buying cars, and they're having difficulty refinancing their homes despite the drop in mortgage rates, because lending standards have tightened and the current value of their homes in many cases are less than what they owe, he points out.
"The mechanism to allow individuals to contribute to a recovery by taking advantage of lower interest rates is broken," says Glocke.
Although he believes the Fed still has the ability to manage interest rates through direct purchases of agency debentures, mortgage-backed securities, and/or U.S. Treasury securities, the economic recovery will rest more on a fiscal stimulus coming out of Washington than monetary stimulus at this point, Glocke says.
Investors are selling some of the Treasuries they previously loaded up on and are taking a chance on higher-risk debt instruments—not because the economy looks any better than it did a month ago, but because they now recognize they're being paid to take the extra risk, says Jackson at Riversource. Some high-yield bonds are paying around 18%, not far below the 20% they paid in the fourth quarter, he adds.
The attraction of other assets, such as short-maturity FDIC-backed corporate debt, is that they're priced more cheaply than comparable Treasury bills and offer yields 0.70% to 0.80% higher than Treasuries. There are also municipal bonds with higher yields, whether investors need the tax advantage that comes with them or not, says James Sarni, managing principal at Payden & Rygel in Los Angeles.
"Treasury yields dropped to such low levels [by the end of 2008] that they just didn't make sense anymore, given the supply expected in 2009 and the yield spreads available in other assets that are either implicitly or explicitly backed by the government," says Sarni.
A Roof on Rates
On Jan. 28, the yield on the 30-year Treasury bond topped 3.40%, after falling to a record low of just over 2.5% in December, while the 10-year note yielded 2.67%, vs. a low near 2.0%. This isn't a secular rise in interest rates, "just a bit of a reversal of the precipitous declines we've seen" as investors diversify out of Treasuries, says Sarni. A very weak global economy will keep a ceiling on rates, while any positive economic news could give another 20-basis-point boost to Treasury yields, he predicts.
Another reason for the substitution of higher-yielding corporate debt for Treasuries is less obvious: demand from nontraditional debt investors, including mutual fund managers who think the risk/reward on bonds of certain companies at this time is better than on the corresponding stock, according to Robert Kowit, senior portfolio manager in the Global Fixed Income Group at Federated Investors (FII).
This is particularly true for mutual funds that track major indexes, such as the S&P 500, and need to maintain some exposure to such key companies as General Electric (GE) or Johnson & Johnson (JNJ) that the indexes hold. "If you have to have exposure to a corporate name at this stage and you're trying to minimize your risk because you think there's going to be a lot of volatility, you might choose to own short- to medium-term bonds instead of equities," he says.
Stocks Can Hardly Compete
The yield spreads of speculative-grade corporate debt over Treasuries have gotten so wide that the absolute yields are well into the double-digit range. If you buy a 10-year bond with a 15% yield to maturity, you're getting a 15% return per year. The stock price of the same company would have to appreciate 15% annually to provide the same return, and very few stocks can do that for 10 years, says Kowit. These fund managers believe the market has already done a pretty good job of pricing the risk of additional corporate bankruptcy filings into the investment-grade and high-yield corporate bond markets, he adds.
And if a massive rally materializes in the stock market, there's nothing preventing portfolio managers from selling the bonds and buying the stock, Kowit says.
The Bloomberg terminals that many money managers and traders use feature a new function called Equity Volatility & Credit Risk, which lists all the companies in whatever global index you select and calculates the relative value of each company's bonds vs. its equity.
"If Bloomberg has taken the time and effort to put together a calculator like that, it's a pretty safe bet that people are viewing things in those terms," says Kowit.
Coupon Yields Are Safer
Companies are more concerned about maintaining their credit ratings and are likely to favor bond investors by cutting dividends to equity investors, he says. Investors also understand that in the event of bankruptcy, they're more likely to lose their equity investment before their debt investment. "It's a very simplistic way of playing the capital structure and investing in a corporate entity," he says.
As for how much the spreads between high-yield corporate bonds and Treasuries are likely to shrink, most of the narrowing will probably be due to declining yields on high-yield debt as investor demand grows, says Riversource's Jackson. He expects the premium on high-yield bonds to pull back to the more normal 5% to 10% range within two to three years. Given the likelihood of a fair number of corporate bankruptcies this year, investors drawn to mutual funds that are focused on high-yield bonds need to be careful when choosing a portfolio manager, he says.
As long as you're comfortable with the risks, corporate bonds could wind up to be a good place to put your money until the economy recovers.