Friday, May 22, 2009

High Quality Credit Risk vs. Duration Risk

As the yield on the 30 Year Treasury has spiked in recent months from a low of 2.5% all the way up to 4.3%, the yield to worst on the Barclays Aggregate Bond Index (i.e. formerly the Lehman Brothers Aggregate Bond Index - a blend of intermediate bonds made up by ~1/3 Agency Mortgage Bonds, ~1/3 Treasuries, ~1/3 Investment Grade Corporate Bonds) has tightened to 3.9% from over 5.5% as recently as October.

In other words, the appetite for "high quality spread" has increased relative to duration (i.e. interest rate) risk, thus bringing down the required return of intermediate bonds relative to the 30 year Treasury. If this 3.9% yield results in dissatisfaction for those risk taking investors, then it may mean a rotation to equities and/or higher risk assets.

While I personally am still vehemently opposed to investing in equities at this time (I can't look at the fundamentals of the economy in its current state and put my money at risk at the bottom of the capital structure REGARDLESS of valuation), the chart below tells a different story. The chart shows the difference between the 30 Year Treasury Bond's yield and the yield to worst for the Aggregate Bond Index, against the one year forward return on the S&P 500 and we do see a relationship.

When the spread turned negative (i.e. investors were less worried about duration risk, then taking on spread risk) it looks like equities underperformed in the ensuing 12 months, possibly as institutional investors reallocated from equities to greater yielding credit. On the other hand when the spread turned positive (such as today), investors became increasingly worried about duration risk and moved to equities.

There is, as always, a "this time is different" caveat. Much of the reason for this high quality spread tightening has been technical in nature as the Fed and Treasury continue to throw money at all the economy's problems. Both Agency MBS (the Fed is actively buying mortgages) and Investment Grade Bonds (think TARP injections to financials) have benefitted by this money at the margin.

And all that money comes at a cost... new Treasury sales and higher Treasury yields.

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