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Even Bonds Offer Good Value Now
By: Dr. Charles Lieberman
Date: 2/9/2009
The sharp decline in capital markets depressed bond prices sufficiently that investors are now nicely compensated for the risks they take when they buy corporate bonds, unlike market conditions just six months ago. Even high-yield bonds are now very attractive, although these will remain quite risky until credit market conditions return to normal. Most investors would likely be far more comfortable with investment grade bonds, although these yields have declined off recent highs. In contrast, government bonds remain in bubble territory and should be avoided, especially longer maturities that offer an unattractive mix of price risk with low returns.
Most bonds sold off very sharply as the credit markets shut down. Investors feared that corporate default rates would soar and the debt markets became highly illiquid. Yields rose to exceptionally high levels compared to inflation. As the markets regain some footing, the high grade end of the market is recovering first, as would be expected. New bond issuance picked up strongly in January and those issues were very well received, typically trading up to solid premiums within days after the issues started to trade. Just as importantly, this sent a signal that fixed-income investors are looking for more bonds to buy. At least in part, this reflects the lack of available supply in dealer inventories, which were cut to reduce dealer capital requirements. So, new issues are a key source of supply to investors who are looking for bonds for investment.
As would be expected, the high grade end of the spectrum is recovering first. High yield has rallied, but spreads on such bonds are still exceptionally high and embed default rates not seen since the Great Depression. Unless default rates surge, these junk bonds will provide equity-like returns to those investors able to purchase such risky holdings. But this risk will remain high until credit conditions revert to normal. In contrast, yields on Treasuries are rising rapidly, as investors respond to improving credit market conditions and become less risk averse.
Most investors will be far more comfortable acquiring investment grade bonds, which offer more attractive yields than has been seen in many years. However, once the Fed Treasury starts the TALF program by buying asset-backed and other less liquid fixed-income products, spreads to Treasuries on corporate bonds will get another push down, as investors find fewer or less attractive outlets in their search for yield. The key is to buy before the Fed really gets into the game buying asset-backed and mortgage bonds in major size.
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