Wednesday, June 1, 2011

I Know I Was Looking for Lower Yields, But This is Ridiculous

I have been writing on this blog for last year or so that I expected interest rates to move lower, not higher.

This has been a decidedly out-of-consensus view. Most commentators and investors were convinced that rates were headed higher, including one of the best bond managers of our generation, Bill Gross of Pimco.

So what's happened?

Rates are plunging lower. At this writing the 10 year Treasury is yielding less than 3%, down nearly 75 basis points from just 4 months ago. The 2- year Treasury note offers a whopping 0.48%.

Corporate and high yield debt yields are also moving lower. Yesterday's Bloomberg pointed out that for the first time since 1987, the earnings yield of the S&P 500 is higher than the average yield on junk bonds, according to Barclays.

Investors and savers are dying for yield, and yet there is little to be had.

All of this is happening against a backdrop of considerably improved economic conditions than 2 years ago. Most corporations are reporting good, if not, record earnings, despite tepid top line growth. Stocks have nearly doubled since the lows of March 2009.

Still, rates are moving lower because housing prices are moving sharply down, and the economy is showing signs of slowing.

Low interest rates, at some point, become a curse, not a blessing.

Or, to put it another way, I kinda wish that I had been wrong on rates, and that the so-called bond vigilantes had pushed interest rates higher.

I manage a number of balanced portfolios for clients, using a combination of stocks and high quality bonds. The idea of bonds in these accounts is to provide some measure of protection, and hopefully some modest degree of income.

Problem is, that if interest rates don't move higher soon, it will be harder to maintain a significant weighting in bonds.

One of the best alternatives to bonds, it seems to me, remains large cap, dividend-paying common stocks. True, stock prices can be volatile, but it seems reasonable that the value of most stocks will be higher 5 years from now than they are today.