August 14, 2010

Yield Pigs

Several blogs, here, here and here, talked about the “insanity” of the bond markets. I tend to agree with the analysis. However what I am noticing is the other dimension of the insanity in the credit market is the rally in government bonds at the same time as junk and corporate bonds.

In the recovery from the March lows last year, the long term yield t-bill went up, prices went down, as money shifted from safe and liquid treasuries to other credits as they were priced attractively. Several credit classes rallied; corporate debt, junk and municipal bonds. The inverse relationship between treasuries and risky asset classes work 9 out 10 times. However, there is something amiss here.

Treasuries are rallying but at the same time so is credit. Most funds are being crowded out from some of the deals hitting the market. Spreads are coming down yet 10 yr treasuries are yielding under 2.8%. Everyone is a yield pig today ( see post about Klarman).

Moreover if I look at the retail investor instruments such as Closed End Funds (CEF), I find huge premiums for high distribution CEFs. High yielding CEF are trading at large premiums, sometimes reaching 40 and 50%. I put the premium along with distribution yield and got the chart below. It shows a clear relationship between yield and the premium. Investors are bidding up funds with large yields.

Actually anything with yields have rallied. The Wallstreet Journal has a story about investor appetite for Master Limited Partnership (MLP) for their out-sized yield.

I usually will bet with those buying government bonds. Government bond market is the largest and the most sophisticated in any asset class. Usually the message sent by the government yield trumps all other. However it may be different this time.

The Globe & Mail reports” ...the government bond market has been flooded by retail investors seeking what they consider a safer harbour than stocks for their investment dollars. U.S. bond funds have posted net inflows for 72 of the past 73 weeks. according to data compiled by EPFR Global of Cambridge, Mass. The bulk of that money has been earmarked for government issues, including municipal debt.”

The rally in US treasuries are perplexing given the fiscal and monetary policies of the US. Spending and loose monetary policies over extended period of time should push yields higher. The US treasury is indicating that there are no policy issues to worry about, while clearly there are many structural issues that should push yields higher, not limited to:
  • Social Security obligations
  • Health care obligations
  • Public Pension future obligation
  • State and municipal deficits and debt
The article brings an interesting conclusion: “....Baby boomers have lived through two 50 per cent market crashes and they are just leaving [equities]” in the mistaken belief they can do better in bonds.”

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