The Impact of Low Rates Through 2014

Bloomberg details the latest from the Fed:

Chairman Ben S. Bernanke said the Federal Reserve is considering additional asset purchases to boost growth after extending its pledge to keep interest rates low through at least late 2014.

Policy makers are “prepared to provide further monetary accommodation if employment is not making sufficient progress towards our assessment of its maximum level, or if inflation shows signs of moving further below its mandate-consistent rate."

The immediate market reaction was a risk asset rally, a huge rally in gold (per Calculated Risk: Bernanke made it clear that even if inflation moved above the target - and unemployment was still very high - the Fed would only slowly pursue policies to reduce the inflation rate), and a rally at the belly of the yield curve (the yield curve flattened out to five years... shorter rates couldn't fall as they are already at or near zero). Why? The "late 2014" date is much later than the June 2013 date previously projected by Bernanke last summer.

The impact of this announcement (and the previous projected rates) can be seen in the chart below that shows the Fed Funds rate curve (implied by EuroDollar futures) for March 2013 through December 2014, as of various dates over the past year.

What do we see? We see an initial drop between March and June of last year as Bernanke indicated low yields for the foreseeable future, then a huge drop (mid-summer) after Bernanke stated rates would remain zero through June 2013. Today's announcement really did nothing through June 2013 (that was already projected), but was felt further out along the curve.

The key question is what is the Fed trying to accomplish?

In "normal" times, low yields = cheap financing = increased consumption (it creates an incentive for individuals to borrow and banks to lend), but in today's zero-bound world the impact is minimal. Increased consumption is limited as individuals are trying to rebuild their own balance sheets and those that might benefit most from borrowing, don't necessarily have the credit to qualify for a loan. In terms of impact on unemployment, GYSC (of Economic Disconnect fame) states:

Unemployment is a structural problem, not a cyclical one, but the FED is still stuck in the past.

In addition, there are some theories that consumption may actually be negatively impacted by zero bound rates. As I outlined over the summer, I think it is possible that negative real interest rates may actually cause individuals to save more, while Kid Dynamite outlined yesterday that low rates forecasted may cause individuals to hold off from making a loan fueled purchase:

Let me explain: right now, one appealing factor of home buying/selling decisions is that interest rates are very low – you can afford to buy more house. If I think that interest rates are going to remain low for a long period of time, I will be in no hurry to lock in this low rate on the debt I’m borrowing – I will be in no hurry to go out and buy a house.

So what is it then? Corporations!

There is one sector that I think will be positively impacted by the latest announcement.... corporations. Don't let their record profits as a percent of GDP (while personal income is at record lows) fool you into thinking they don't need help at the populations expense. Seriously though... my initial reaction upon hearing that rates would be held down near zero through 2014... buy credit... WITH duration out to around ten years (the secondary impact is positive for equities, as explained below).

While Treasury yields are at all-time lows, corporate spreads remain at elevated levels (when yields fell during the summer when we had to deal with the US downgrade and Europe, spreads widened significantly).

In "normal" times, when markets calm these spreads would be expected to narrow, which I still believe is the case. One would also "normally" expect Treasury yields to rise as investors shift out of Treasuries, causing the hard interest rate component of corporate yields (rate + spread = yield) to rise, but this risk has been removed for the foreseeable future out to around ten years. The result is that corporate bonds seem like a very safe investment. This decreased risk should mean even cheaper financing for longer dated maturity corporate bond issuance.

So will this finally set off a round of corporate fueled expansion? If they don't see aggregate demand improving, then I don't see how this will impact the underlying economy. But, with the cost of equity high (i.e. what I perceive as fair to cheap equity valuations) and cost of debt low (i.e. these lower yielding corporate bonds), we may see significant change in capital structures (perhaps via private equity).

Source: Barclays Capital

Why Do Large Cap Firm's Trade at a Discount to Market?

Aleph Blog outlines why he believes "behemoth" companies (i.e. firms with a market value greater than $100 billion) trade at relatively compressed price to earnings ratios:

For Behemoth companies to achieve large earnings growth, they have to find monster-sized innovations to do so. Those don’t come along too regularly. Even for a company as creative as Apple (or Google), it becomes progressively more difficult to create products that will raise earnings by a high percentage quarter after quarter.

As a result it should not be a surprise that Behemoth stocks trade at discounts to the market when global growth prospects are poor. They have more assets and free cash flow to put to work than is useful in a bad environment. Not every environment offers large opportunities.

The below chart outlines, by sector, the market cap of the current 39 behemoths using data from a follow up post at Aleph Blog (he adds even more granularity in his post).

I would also add that I believe these behemoths trade at an aggregate discount due in part by their composition. Financials (and to a lesser extent energy firms) trade at a large discount due to the damage they inflicted upon themselves and the threat of future regulatory restrictions that may impede profitability, both of which may force them to dilute shareholders as they raise / write-down capital. Technology firms on the other hand are constantly threatened by innovation and becoming irrelevant by the next generation of firms (i.e. what happened to Yahoo via Google), thus earnings become difficult to project past even a few years.

The History of Corporate Bonds

Long way down....

Soure: Barclays Capital

Corporate Bond Performance

Year to date performance of corporate bonds (investment grade rated bonds AAA --> BBB / high yield bonds rated below BBB) is shown below. What is rather (in my opinion) amazing is that the top performing corporate bond quality by rating (BB) are up only ~4% from the bottom performing corporate bond quality by rating (AA).



Why amazing? Take a look at the below, which details the top performing corporate bond quality by rating and the bottom.



Some initial thoughts that come to mind...

The Fed has been performing a balancing act due to the slow down in growth (i.e. when high quality assets "should" outperform) by providing a TON of liquidity (i.e. when low quality assets "should" outperform). The fact that all corporate bonds by quality are performing relatively in-line (and doing well in absolute terms) shows me that the Fed is doing their job quite well or that the market does not know how to interpret what they are doing, thus not differentiating between high and low quality (I am inclined to think the latter).

And because I was digging through data... some longer term analysis of the various quality by rating of corporate bonds (annualized performance vs. annual volatility). Broadly, more risk = more return until an investor reaches too much for yield (below BB). Note that information ratio below is defined as excess risk to T-Bills / annual volatility.



Source: Barclays Capital

Is the Low Quality Rally in Corporates Over?

Bloomberg details:

Returns on U.S. investment-grade corporate bonds are pulling ahead of junk-rated debt as credit investors turn to borrowers likely to weather a slowing economy.

Investment-grade bonds are up 9.7 percent this year, topping the 8.5 percent for speculative-grade, the biggest outperformance since credit markets seized up in 2008.

Yields on investment-grade bonds average about 4.71 percentage points less than junk, compared with 3.76 percentage points in April.

Performance by Rating



Source: Barclays Capital

The Value of Corporate Bonds

WSJ (hat tip Abnormal Returns) details:

Since peaking in mid-January, corporate-bond prices have had their biggest decline since a breakneck rally that began last March. That climb had made it cheaper for companies to finance operations, greasing the skids of the economy.

This past week, though, the cost of protecting against corporate defaults rose to the highest level in three months. Returns on high-yield debt turned negative for the year. And companies, after raising record amounts of new debt earlier this year, abruptly trimmed the amount of new debt they brought to market. Some were forced to cancel sales.

Even after the market's recent declines, many analysts aren't expecting much, if any, of a rebound.

"The move from here gets a lot tougher," said Morgan Stanley credit strategist Rizwan Hussain. "We are now basically back to what looks like a typical credit recovery."

While not exactly a sell-off, after the one direction bet we've seen with corporate bonds over the last 12 months ( that has narrowed the spread on the broader corporate bond benchmark from 600+ bps to less than 200 bps), the value of corporate bonds becomes as dependent on expectations of interest rates as on future spread compression.

Source: Barclays Capital

Corporate Bonds: From Cheap to Rich

In March I loaded up on both investment grade and high yield bonds (see Are Corporate Bonds a Screaming Buy?) as a long term investment (the key I thought was long term).

Yet by July, I was already beginning to cash out of the positions as I thought they had rebounded too far, too fast. 5% more gains for the investment grade and 20% for the high yield universes gets us to a point where bonds went from CHEAP to what now seems RICH in just about 6 months. Bloomberg details the implications and relative value of bonds to equities:

Stocks offer greater value than bonds and are poised to “catch up” with a rally in corporate debt, according to Rod Smyth, chief investment strategist at Riverfront Investment Group LLC.

The CHART OF THE DAY shows that the difference in yield between corporates and 10-year Treasury notes has narrowed more quickly than the Standard & Poor’s 500 Index has risen since March. The yield comparison is based on a Moody’s Investors Service index of Baa-rated debt. Smyth and colleagues Bill Ryder and Ken Liu had a similar chart in a report yesterday.

Since December, the yield gap has fallen to 2.9 percentage points from a peak of 6.2 points, according to data compiled by Bloomberg. This spread is near its lowest level since January 2008, when the S&P 500 was about 22 percent higher.

“‘Animal spirits’ are returning to Wall Street even if they are still suppressed on Main Street,” the report said. Spreads have narrowed so much that stocks have more room to rise than bonds, especially as earnings increase, it added.

Smyth isn’t the only strategist whose focus has shifted to shares. “Equities no longer look expensive relative to corporate bonds,” Andrew Garthwaite, a global strategist at Credit Suisse AG, wrote in a Sept. 18 report. He downgraded credit, or bonds, based on relative value.

While I am much less than bullish (actually bearish) on equities than those quoted in the article, it is suspicious how far high yield has rebounded in 2009 as compared to equities. While those BBB bonds (as detailed in the article) are now up more than 20% YTD, high yield corporate bonds are now up almost 50%.



Source: Barclays

Putting the Credit Crisis in Perspective

While I am still relatively bearish with regards to a further economic / market recovery, I am amazed at how fast a recovery we have had in credit markets. We were on the verge of a Great Depression type crisis until just ~6 months ago (so soon we forget), but have rebounded with unreal zeal.

How unreal? Lets compare the recent ongoings in the credit market with that of the Big D to put the crisis (and recovery) in perspective. While they never blew out to the level seen in the 1930's, the spread between AAA corporates and BBB corporates are now within 100 bps of the levels at the start of the crisis, just 2 years after the blowout began. That is 3x faster than seen in the Great Depression.



My question (which may be getting old) is... have we come "too far, too fast"? My view is a resounding yes, thus tread carefully.

Source: St. Louis Fed

Investment Grade Corporate Bond Yield

We've detailed similar thoughts here and here, but worth repeating. While the borrowing cost for corporations that have been able to maintain their AAA or AA rating (not many) has stayed relatively flat, for other Investment Grade borrowers... not so much.



Source: Barclays

Abnormal Markets...

High yield bonds are outperforming investment grade corporate bonds, which are outperforming equities (year to date 2009).



How rare is this? Well, this hasn't happened over a full year since 1993 when all three were positive.



And the last time high yield had positive returns, while investment grade bonds and equities had negative returns... well I don't have enough data to tell if that's ever happened.

Are Corporate Bonds a Screaming Buy?

I've had two "screaming buys" since I've started EconomPic. The first was on October 9th, with my post Muni Close-end Funds SCREAMING Buy? Since that date, the muni close-end fund I was tracking is up more than 40%.



The second screaming buy was on November 11th, titled Are Convertible Bonds a "Screaming Buy"? Since that date, convertible bonds are up 6%, significantly more than equities.



What this shows is two-fold:

• My screaming buys are batting 1000
• I'm lucky

Please keep in mind that there are no guarantees in this world (especially when that information is from a blog) BUT, with the price of corporate bonds implying default rates on investment grade rated bonds anywhere between 6-10% and those on high-yield corporate bonds between 30-40% (the wide range allows for a plug figure for recovery given default - the more money you get back given default, the less it will impact the pricing of a security), compared with the historical defaults below... corporate bonds are my next SCREAMING BUY.



EconomPic is far from alone on this call. In fact, Aleph Blog goes one step further:

At a time like this, I reissue my call to sell stocks and buy corporate bonds, even junk bonds. When the advantage of corporate bond yields are so large over the earnings yields of common stocks, there is no contest. When the yield advantage is more than 4%, bonds win. It is more like 6% now, so enjoy the relatively stable returns from corporate bonds.

A real threat I see in the short-run is that cheap investments CAN (and often DO) get cheaper. In addition, a lot of corporations are issuing new debt into an illiquid market, increasing the likelihood of short-term volatility. In the longer run a legitimate threat is the duration risk associated with corporate bonds (i.e. the likelihood of interest rates rising).

Overall, I am 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.

I hope I'm still be batting 1000 when I offer my next "screaming buy".

Source: Moodys

A Chart Worth 1000 Words? Corporate Bond Spreads (Now vs. Then)

Update: I received some feedback questioning where on the corporate curve I was pulling my data, so I've provided the detail for the original (five year maturity) and update (full corporate and high yield indices).

The spread of a AAA rated corporate bond today = the spread of a single B corporate bond less than two years back.

Original: Spread to Treasuries (5-Year Maturity)


Update: Spread to Treasuries (Full Indices)


Source: Barclays

"Cash Rules Everything Around Me"

Business Week details:

At a time when the economy is experiencing its steepest drop-off since the depths of the 1982 recession, it's perhaps not surprising that cash is the new black at big corporations—and the bigger the pile, the better. With that in mind, BusinessWeek sought out 21 U.S. outfits that most aggressively stockpiled cash in the most recent quarter. Collectively, this group of companies added $83.7 billion to their balance sheets. By contrast, they reduced their cash by a total of $808 million during the same quarter of 2007.

Investment Grade Bonds: Attractively Priced, But With Reason

While the Barclays Capital Investment Grade Index has rallied significantly over the past few months (from slightly more than 9% to just over 7%), the yield is still significantly higher than it was pre-financial crisis, presenting what appears to be a great investment opportunity.



While a portion of this is due to the sell-off across investment grade corporate bonds, another explanation lies in the composition of the index. Since January 2007, the composition of the index has stayed relatively static with regards to holdings of Aaa and Baa rated securities. However, there has been a 7% shift by market value from Aa rated to A rated securities due to downgrades (in addition there have been downgrades from A to Baa, and Baa to high yield, which brings up survivorship bias, but that is another post altogether).



The relevance? Since early 2007, the yield of Aaa and Aa securities has stayed flat (though spreads to Treasuries have widened significantly). On the other hand, A and Baa Investment Grade corporates are 140 and 240 bps wider respectively in that period (note the crossing pattern of Baa and A yields in September / October and Aa and Aaa yields currently due to the market's disagreement with the agencies ratings, specifically financials).



In other words, a lot of the increase in 'absolute yield' levels of Investment Grade Corporate Bond indices are due to a worsening of credit, not necessarily pure market opportunity. While I personally find value at these levels, it is important to understand what risks you are taking as an investor.

Not All AA Bonds are the Same

According to Moody's, Aa Bond:

Obligations rated Aa are judged to be of high quality and are subject to very low credit risk, but "their susceptibility to long-term risks appears somewhat greater".

In other words, while they are not bullet-proof like Aaa's, they should have a minor chance of default. Given the current market condition, it is not surprising that financial and insurance company bonds have sold off more than other AA corporates, but it is pretty wild by how much.



The reason? Ignoring the thought that financial bonds have a higher likelihood of default (I can see both sides of this... on their own yes they do, but government assistance will greatly help), it has become painfully clear that the recovery value of these financial bonds given default is slim (Lehman junior debt is trading at close to nil, while CDS on the senior debt paid out less than 10 cents to the dollar).

Spreads: Not Seen Since the Great Depression

JG provided an interesting insight in the comments section of my "Real Yields Matter" post. Credit risk premium, as defined by the difference between the yield of the Moody's Baa and Aaa rated indices (more detail regarding Moody's here), recently moved above 3%. What is the significance?

As of Nov. ‘08, the Baa-Aaa risk premium moved above 3.0%, to 3.07%; in December, it was 3.38%.

When were the last times that the Baa-Aaa risk premium rose above 3.0%? August ‘31, October ‘32, October ‘33, and March ‘38, in the depths of the Lesser Depression (first two) and its protracted recovery (last two).

We are one year into The Greater Depression.

In plotting the data, JG is correct. Although we were awfully close in the early 1980's and 338 bps is a a lot smaller than the 560+ bps we saw in 1932, this does put the current crisis into the correct context.

Source: St. Louis Fed (BBB) / St. Louis Fed (AAA)

Real Yields Matter

Paul Krugman comments:

The really striking thing about corporate borrowing rates isn’t that they’re high by historical standards, although they are, but the fact that they’re high even though interest rates on government debt are very, very low. Below I show the spreads on AAA and Baa debt against 30-year Treasuries: they really have spiked.

Also bear in mind the decline in expected inflation: real corporate rates are very high.

That last sentence is key. Even though Treasury rates have rallied significantly in nominal terms over the past 1 1/2 years, they still yield more in real terms than when the financial crisis began. Corporates, as Paul points out, are the greater issue. Real yields on Investment Grade Corporate Bonds are now 2.5x higher than they were just six months ago.



Throw in a declining economy and the diminished end-user demand we are witnessing across industries, and it is very easy to see why corporations are having such a difficult time.

Fed Funds Cut to 1.5%... Will It Matter?

The cost of borrowing for investment grade corporations has skyrocketed in recent months to a whopping 6% above the Fed Funds rate.


Will the rate cut matter?

The Fed's (Lack of) Impact on Rates

Source: Jim Bianco of Bianco Research via Naked Capitalism.

The Secret Sauce Revealed...

There was a guess that the 'Secret Sauce' was a Corporate Bond Index and one that the 'Secret Sauce' was instead a Treasury Index. As these (actually a combination of the two in the form of a Long Government / Credit Index) formed the 'Secret Sauce', I thought I'd take a look at how well these two security types have performed relative to one another...

The results actually surprised me. While there were somewhat large year to year variations, since 1973 the cumulative returns are remarkably close.