Thursday, February 25, 2010

More on Bonds

The overwhelming consensus remains that interest rates are going to move significantly higher - it's just a question of when. Thus, the "smart money" says to keep your maturities nice and short, wait for interest rates to rise, and then extend.

So that's what the world is doing. If you look at yields on shorter maturity bonds in both the taxable and tax-exempt markets, they are incredibly low. For example, high quality municipal rates do not reach 2% until 2017.

Put another way, investors would rather lock in a total of 10% return for the next 6 years (admittedly tax free) than risk either longer maturity bonds or (gulp) stocks.

All of this in the midst of the following:
  1. Fed Chairman Bernanke reiterated his feeling yesterday that short term rates will stay low for an "extended period of time";
  2. Bank lending has declined at the fastest rate since 1942 (when we were in the midst of World War II, and there was nothing for consumers to buy);
  3. New home sales reached levels not seen since 1963;
  4. Every recent inflation data point released in the last few weeks indicate that prices are low, and possibly heading lower;
  5. With the exception of government spending, every segment of the economy is still paying down debt. Deleveraging economies typically don't see soaring interest rates;
  6. Nearly $4 trillion is stashed in money market funds yielding essentially 0%. How long before the "pain" of no returns begins to hit savers?
As we all know, Greece is going through a major financial crisis, and there is more and more talk of a soverign debt default. Today's Bloomberg indicates that Greece is considering issuing 10 year bonds at a spread of 364 basis points above comparable (and safer) German bonds (this spread is narrower than a month ago, by the way).

However, this would put the yield on near-bankrupt Greece government bonds at around 6.75%. Long maturity US Treasury bonds are yielding anywhere between 3.70% (10 years) and 4.65% (30 years). Unless one believes the credit of the US government is heading the way of Greece (which I don't), what is the market saying about the future?

I continue to believe that the risk to investors is for lower, not higher, interest rates. When all of the high coupon debt that was issued a few years ago starts maturing this year, wait for the "sticker shock" when investors try to replace those coupons.

One final note: it used to be that the shape of the yield curve was an excellent predictor of future economic activity. The steeper the curve, the most positive the outlook, or vice versa.

With the curve at record steepness, does this imply a much more robust economic recovery than anyone is expecting?