Friday, July 10, 2009

Help Jake Invest...

Back in March, I posted my belief that corporate bonds were a "Screaming Buy". At that time I liked being able to move up in the capital structure, while still being able to receive an 8%+ yield for investment grade and 20%+ for high yield. I detailed I was:

Invested at a ratio of ~70% investment grade / ~30% high yield via an assortment of close-end funds trading at a discount. For the record I do not shy away from risk, so my recommendation would be to tone down the high yield exposure if you are more risk averse.
Since the time of the posting, the investment grade bond ETF (LQD) has rallied 11% and the high yield ETF (JNK) around 20%.

In other words, in just three short months, much of that opportunity has already gone.

WSJ reported on the topic:
Nine months later, investment grade corporate bonds have recovered from the shock of Lehman Brothers’ implosion.

Spreads had taken quite the ride since spiking at the end of 2008. They soared as high as Spreads soared as high as 656 basis points December 5 before returning 100 basis points.
The chart below shows the absolute yield of the Investment Grade Corporate Bond index, as well as the spread to Treasuries. While this is a great sign for corporations that can again finance their operations at levels seen pre-Lehman (i.e. less than 6%), it obviously makes corporate bonds less appealing to investors.

But how much less?

I am still not excited about the prospect of moving down the capital structure (i.e. to equities), especially after the massive rebound in risk assets. So, if I were forced to invest in either equity OR corporate bonds, I would definitely be going the investment grade route. But fortunately, I am not forced to invest.

Thus, the question becomes are investors being compensated enough (via spread) to invest in investment grade corporate bonds over Treasuries (or other higher quality assets). In other words is the spread to Treasuries attractive enough to take on the extra credit risk?

There is nobody better to get answers from than David Rosenberg. And he notes:
Baa corporate yields are between 50bps and 250bps wider than they were at the depths of the last three recessions, suggesting that there is a lot of “bad” news still priced in.
To be sure, corporate spreads have come in a long way from their nearby crisis highs but looking at prior peaks around major events and economic downturns, it does appear as though there is still a lot of very bad news priced into the sector.
But again, after the massive rebound in "anything risk" over the past few months I am not so certain about valuation. After all the economic data I've walked through daily over the past year on EconomPic, I am not so certain that 50-250 bps of additional spread relative to the last three recessions is enough compensation for borderline junk bonds. After the recent rally in Treasuries, I am not so certain that I even like duration like I did just 2 1/2 weeks ago when the yield on a ten year Treasury was 50 bps higher.

And if there is anything I have learned as an investor, if you are uncertain... GET THE HELL OUT.

For that reason (in my trading account - my 401k is another story), I am no longer long anything except for volatility and cash (I'm guessing long time readers have an idea where I'm short), but I am looking for ideas.

And it's Friday, so PLEASE slack off a bit and provide a few.

Source: Barclays