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Bail Bonds
Ever get that "feeling?" The one that seems to be telling you that something
is not quite right? Well, we've got that feeling now.
Stocks up. Treasuries and oil up (or at least stable). Corporate bonds up. Gold up. Historically, all major assets classes don't rally together. So now that they are, investors should at least pause to consider what the anomaly might mean.
Looking at the two largest general asset classes (stocks and bonds), one would generally expect to see one of them start to sell off or soften as the other one rallies. That obviously hasn't been the case recently.
Since July 8, the S&P 500 is up 18.7% and the 10-year Treasury has rallied to
a 3.33% yield. This stability is remarkable given the unprecedented government
debt issuance -- a feat few market participants would have thought possible only
a few months ago.
In addition, the spread between high-yield corporate debt and the 10-year
Treasury note has narrowed by 271 basis points even though corporations as a
whole have not seen marked improvement in their business prospects -- an
indication that investors are stretching for yield.
Taking it a step further, it's clear that correlations between some major asset
classes have stepped out of the norm over the past 10 weeks.
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So, what's it all mean?
We've seen many historical correlations break down over the past two years.
Currently, stocks seem to be giving the all clear. Bonds and precious metals,
though, are saying "hold on there just a minute."
One argument for the stock rally is that everything was so oversold that the market is now just returning to where it should be given that the world has not ended. In March the P/E multiple for the S&P 500 hit its lowest level in nearly 25 years.
A case can also be made for the idea that the market will support current
prices, because any time there's a sell-off, there's someone on the sidelines
just waiting to buy on a pullback out of fear that they (and their clients) will
miss the next move up.
On the bond side of things, the reasoning is twofold.
First, inflation is in check and will remain so until unemployment begins to
significantly abate.
Second, there is so much money on the sidelines waiting to be reinvested in
other asset classes that demand will continue to outweigh supply regardless of
how much issuance there is. Indeed, this latter thought seems to playing out
for now -- a stark contrast from the supply concerns that gripped the markets
for the past few months prior to any Treasury auction.
But, you can't date two people forever. Eventually one of the two puts their
foot down and demands your devoted attention or walks away.
If it looks like a bubble and floats like a bubble, it's probably a bubble
At this point, we think there is more long-term risk than reward in the bond
market. We believe that there are always relative fixed income values out there
as long as an investor is comfortable with the interest rate scenario. But,
that doesn't mean bonds won't get clobbered when the interest rate picture
changes.
As such, we are now of the mindset that bond investors should seriously consider
shortening their overall duration. We can't predict exactly when Treasury
yields will move higher (they will be followed by corporates and munis), but we
are confident that the move is likely to be painful for investors who got in at
these yields or lower.
Consider the following graph for the past 10 years:
The green line represents the 5-year-5-year Forward Inflation Expectation
(The expectation shows what the market believes the average annual inflation
rate will be for 5 years, 5 years from today). Notice that even during
periods when the Fed was loosening, or tightening policy (as evidenced by the
fed funds rate), it was only recently that the 5/5 moved significantly out of
its historical range of 2-3%. In addition, the 10-year has traded between 4.00%
and 5.00% the majority of the time.
Looking back to January 2003 (when the 5/5 was first calculated), the
average spread between the 10-year and the 5/5 has been 172 bps. That would
imply that the 10-year yield should be at 3.90% today.
If you limit the data range to January 2003 to Nov. 18, 2008 -- just before the
Treasury market started an extreme run-up that saw the 10-year yield fall as low
as 2.06% and stay below 3.00% until April 29, 2009 -- the average spread is 193
bps, which would mean the 10-year should be closer to a 4.11% yield.
While it's true that numbers and statistical results will vary depending on what
time series are captured and how the data are interpreted, it is also true that
one must start somewhere in order to try and draw any meaningful conclusions.
How much longer will it be sufficient to say, "Well, there's a lot of money out there and no signs of inflation so yields will stay low."
That's all fine and good (and makes sense in the short term), but until
people put some parameters around that statement, it's not very useful. Saying
that you expect the status quo to stay the status quo because nothing is going
to change is the calling card for Captain Obvious.
This is not meant to imply that the stock market has it right. Indeed, we think
that both markets have gotten ahead of themselves. They may both grind to
better levels from here, but the operative word there is "grind."
In lieu of the ongoing economic uncertainties, we find it hard to believe
that the stock market recovery will continue in the same easy, nearly linear
manner seen since March.
"Pain is inevitable. Suffering is optional."
With the exception of clairvoyant market timers (of which there are very
few), pain is an inevitable part of the investment process.
The pain of selling too low and missing out on the upside. The pain of not
buying that stock or bond you just knew was going to take off. The pain of
seeing paper profits clipped. But, that doesn't mean investors have to add
insult to injury by turning the pain into suffering -- especially when a remedy
is readily available.
In particular, Treasury investors should consider the price risk associated with
various points along the curve. In the table below we have assumed a general
flattening of the yield curve in the future -- thus the 100 basis point move on
the short end versus only a 30 basis point move on the long end.
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*Current yield and price assume that investors could buy a
newly issued bond today at the prevailing market yield
If history is any guide, we need look no further than 2001. That
recession was a mild one that lasted only from March to November of that year.
On November 1, the 10-year Treasury hit its low for that period of 4.10%. Six
weeks later, the yield hit 5.39% before pulling back to a 5.03% yield by the end
of the year -- about 90 basis points above its low.
Even if the 10-year rallies to 3.00% before its pullback, a 90 basis point
move would put it back in the 3.90% range eventually. We're not saying that one
can draw a direct correlation between then and now, but it is food for thought.
The risk associated with being out on the far end of the curve is
obvious.
A 30 basis point move in the 30-year costs investors far more money than a
100 basis point move on the short end of the curve. Plus, investors who
purchase 2- or 3-year paper may be able to avoid that principal loss by simply
holding the bond until it reaches maturity. Those in 30-year bonds may not have
that kind of flexibility.
This is not the time you want to be fashionably late to the party.
We may be early on this call, but we can live with that. We are not saying that
inflation is heading north any time soon. Rather, setting aside concerns
the stock market is overextended, we are making the case that Treasuries are
overbought and that the relationship between the 10-year and the 5/5 may soon
start to work its way back to a more historically normal spread.
Investors who have logged solid unrealized gains in longer maturity bonds so far
this year may want to consider taking some money off the table and shortening
their duration to protect current gains as well as limit downside risk.
As an alternative, investors who have portfolios that are heavily overweight
on the long end may want to purchase some shorter maturity bonds to decrease
overall duration (heavy on the short end of the barbell).
Below you will find some alternatives to Treasuries that investors might want to
consider, taking into account that some managers have to be at least somewhat
long to match future liabilities (all spreads are to comparable Treasuries).
All instruments in the table are considered investment grade securities and are non-callable aside from make-whole calls. However, ratings are not all equal and there is variation among the maturity dates.
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