Thursday, December 11, 2008

Stocks Say Recession, but Bonds Say Depression

Extraordinary things are happening in bondland lately. Tuesday's head-spinning news that Treasury bills had been auctioned off with negative interest rates is only the latest in a series of astonishing developments, surpassing even the more widely followed stock-market swings.

While the Treasury auction grabbed headlines, corporate bonds are doing equally amazing things: the average yield on lower-quality investment-grade corporate bonds — triple-B rated — is hovering around 10%, an unusually rich 7.5-percentage-point spread over Treasury bonds of similar maturity. (That spread has tripled over the past year.) Or consider junk bonds, as measured by Merrill Lynch's High Yield bond index, which yield a jaw-dropping 22%. Of course, junk bonds come from the riskiest borrowers, and a deep recession could drive up the default rate among those companies. But current lofty yields imply investor expectations that one-fifth of these bonds will default, according to Moody's, even though the recent default rate in this sector has been around 3%. Notes Kirk Hartman, chief investment officer for Wells Capital Management, a division of Wells Fargo bank: "Spreads [over Treasuries] in the bond market are pricing in a depression scenario, while the equity markets, despite a substantial decline, are pricing in a recession." (Read "The Recession Is Made Official [EM] and Stocks Take a Dive.")

Many factors weigh on the bond market, such as the falling price of oil — it closed at $43.52 per bbl. in Wednesday's trading — and the progress of the auto-industry bailout, not to mention every gasp from the housing market. And then there's the elephant in the room: the downward spiral of economic activity, including last week's chilling November employment report, which showed 533,000 more people out of work — "one of the worst ever," according to Morgan Stanley economist Ted Wieseman. As the various industry bailouts — banks, auto companies, credit unions and, next, states — seek to reassure investors, collectively they confirm just how bad things are.

But at its current extreme, bond-investor fear is myopic. In striving to avoid the falling stock market and the downdraft of the economy, investors are all but ignoring the longer-term inflationary implications of a monetary easing and explosive growth in U.S. government spending and what it could ultimately mean to bond yields. At Thursday's close, for example, the 30-year T-bond was yielding 3.07%, implying investor expectations for stable prices for decades to come. Inflation-protected Treasuries, known as TIPS, are yielding so little that money managers say they imply investor expectations for a deflationary environment for the next few years. All of which points to the fact that nobody really cares about inflation dangers at this point; it's all about safety.

So how should investors approach the bifurcated bond market? Should they run for the safety of Treasuries or consider the neck-wrenching yields now available in other sectors? Notes money manager Hartman: "From a relative-value standpoint, bonds offer an unusual investment opportunity" that he expects to pay off once the housing market bottoms and the financial outlook improves. "Investment-grade corporate bonds are very cheap, and high-yield bonds similarly offer great value at these levels," he says. Treasury bonds on the other hand, are widely viewed as overvalued on the basis of what can only be characterized as the Armageddon-anxiety rally of the past few months. They could wallop investors with losses should the economic recovery take hold next year.

-- John Curran (Time)


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