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


  1. Jake,

    I think you have the right idea - be careful. Asset valuations aren't at historic lows, especially give the backdrop of historic debt levels. It's hard to earn money, but easy to lose it.

    If you want to take some risk, be patient and even then be nimble. Take advantage of situations like the LQD & JNK sell-offs you found. Good deals are rare and they don't last long.

    The nice thing is that you actually think for yourself. Most don't. And, unlike hedge funds, you don't have a year end performance deadline or a high water mark.

  2. Rates are still very low, so absolute returns for bonds still aren't stellar, despite record spreads. Deflation will likely add a little more to real yields, but currency stability is a real question that has inflation and bond demand implications. Volatility and short duration seems like sound advice.

  3. How about the utilities sector? It hasn't much participated in the rally, but earnings have still held up.

  4. Jake keep up the good work. I've bookmarked ya.

  5. Hey Jake sorry to see you out of the markets.
    I'm starting to go back in heavy after exiting near the top and locking at the highest interest rate before they plummeted.
    Too much doom and gloom = massive buy signals.
    I love it when ppl try and guess the bottom, there are always pockets of value in these situations.
    Sure we might go down more but seriously i can buy many stocks for 20c in the dollar with no debt. I dont understand why we are all worried. We should have been worried at 14,000 not now!

  6. good stuff Jake. I've seen a lot of smart people like yourself come out and question if the risk/reward profile is worth it in corporates and junk bonds lately. But, I also think your point about preferring them to equities is still a prudent one. Will be interesting to watch going forward.


  7. i absolutely agree with you Jake,

    i got myself out of my trading position in corporates three weeks ago.

    it seems i might have been early but risk-reward doesn´t look good anymore.

    here´s why:

    -the trade is overcrowded.
    there was a pure mania in corporates. everybody was touting it, inflows have been huge. i´m sure there are a lot of retail investors who bought but have no exact idea what they´re investing in.
    so far there´s been only one way (up) - but once it turns, the herd coug ignite a selloff.

    -true. spreads are below their peaks.
    but i do think that we´re in a completely new world of less leverage.
    you just cannot take the highs or even the average of the last 10years as a benchmark.

    -spreads are pricing in a decent economic recovery. i´m still not convinced that is really going to happen.

    -finally you trade corporates not by spreads alone. there´s still the overall interest rate risk.
    though i have a deflationary bias i still don´t know which way we will go.
    you latest charts on CPI and the rate of change in utilization made me think again. inflation and hence higher rates might return sooner than thougt.

    so all in all i don´t like risk-reward at this point.

    as a stock trader i run a portfolio of balance short and long positions. right now i´m underinvested waiting for hints out of the earnings season.
    my long term view is still bearish. so i can´t recommend buy+hold stocks.

    CASH is a position.

    those who have the ability to be PATIENT (if necessary for months) will be rewarded.