A Turning Point in the Bond Markets

"It is always darkest just before the dawn." This very old and somewhat trite saying, is nevertheless very true (unless the moon happens to be high in the sky at 4am). It goes for our financial markets and the economy as well. We are in the deepest economic decline since the Great Depression. And if not for quick action by our Federal government, we might even exceed the depths of "The Greatest". Whether you agree or disagree with the philosophy of a central bank that interposes itself into market workings, it is hard to deny it is having some effect.

Yesterday, Ben Bernanke shocked the world by dropping the overnight Fed Funds rate (rate at which banks can borrow very short term from the Fed) to 0-0.25%. Basically, free money. In one way, this is just recognition that is where the short term Treasury rates are anyway. No point in keeping the overnite rate at 1.0% when the 3 month and 6 month Treasury bonds are yielding 0.01% and 0.2% respectively as of today. For these rates to be good investments, the currency MUST deflate (each dollar be worth more at a later date). But more likely, the buyer of such Treasuries just is making sure he still has tomorrow what he has today.

The past few weeks have also put to bed any notion that Gold is the world's safe haven currency. There has never been a time, probably not even the 1930s, when such a currency has been more in demand than right now. Yet, what do the world's investors flee to in times of absolute financial terror? Gold?.... No way....US Treasuries, instead. The irony is that the more money the Feds print, the more expensive it gets as measured by higher priced / lower yield US Treasury bonds. What a deal the Feds have (and by extension, we taxpayers). This anomaly is allowing the Fed and Treasury to buy up all the toxic mortgage and corporate debt at almost no cost to the taxpayer, at least not yet!

What this all suggests is that we are at another bottom of sorts, a yield bottom. Or to take the inverse, we are at a Treasury bond market top. Tops and bottoms when they can be identified, always make for a good time to evaluate a position and make changes to it. There are two possible routes in the bond world that make excellent sense at this time. One, go short the Treasury bonds by selling short Treasury ETFs, like (IEF), or by buying Ultrashort Treasury ETFs like (PST).

Another really good strategy at a yield bottom like now, is to go to the other end of the credit quality spectrum and buy the hated high yield (junk) bonds that now at historic spreads (differentials) to Treasuries. Even James Grant, a super-contrarian who called the credit and market crash years before it happened, likes high yield corporates and senior bank notes at this stage (see below). Today's high yield bonds are at a 20% spread over Treasuries (which is to say they are yielding right about 20% with Treasuries near zero). The normal spread of high yield corporates over Treasuries is around 6-7%, and the spread was as low as 4% in 2006. There will eventually be a reversion to the mean. Moving from 20% spread to 7% spread should result in at least a double for the high yield market. In the meantime, reinvest the 20% annual dividends to buy more fund shares.

I am counting on the Fed fiscal and monetary actions to turn around the economy, forestalling any wide spread defaults on corporate debt. I personally have loaded up on junk funds. I am buying into the Fidelity Advisor High Income fund (SPHIX). Another good mutual fund I have owned in the past (in 2002-03 before the recovery in that cycle) is Vanguard's High Yield, (VWEHX). A new low cost IShares ETF is also available under the ticker (HYG). I have done a comparison and all three trade in lockstep and have a similar yield around 12% as of today (a little lower than the junk bond universe because the quality is somewhat better in these funds). So, pick your favorite fund company and go with it.

Here is what James Grant said yesterday about a similar class of investments, senior bank loans, which have been heavily sold as a result of the hedge fund unwind. Senior bank loans were part of the "carry trade" play, with hedge funds borrowing short term, low interest loans like Japanese bonds, and then buying higher yielding funds like the senior bank loans. As hedge funds were forced to meet redemptions the past six months, Seniors and High Yields, were sold off indiscriminately:

Grant Says Forced Sales Create Opportunities in Bonds

By Carol Massar and Gabrielle Coppola
Dec. 17 (Bloomberg) --

Investors seeking safety in Treasuries may be missing out on opportunities created by forced selling in credit markets, according to James Grant, editor of Grant’s Interest Rate Observer.
Investment-grade corporate bonds are paying record yields relative to benchmark rates, “in this time of zero yield elsewhere,” Grant said today in a Bloomberg Television interview. Residential mortgage-backed securities and bank loans secured by assets are also attractive now because money managers forced to dump the securities to meet investor redemptions have made them artificially cheap, he said.

Yields on investment-grade bonds relative to benchmark rates have hovered near record highs as investors shun all but the safest debt in the deepest economic crisis since the Great Depression. The Federal Reserve cut its benchmark interest rate to as little as zero yesterday, further reducing yields on Treasuries, to try to ease the yearlong recession.

“Of course there’s trouble, that’s why there’s a bear market,” Grant said. “But that’s when you’re supposed to be interested in value. It’s not when everyone’s happy.”

The average yield over benchmark rates on investment-grade corporate bonds was 651 basis points yesterday, 5 basis points shy of the record high set Dec. 5, according to Merrill Lynch & Co.’s U.S. Corporate Master index. A basis point is 0.01 percentage point.

Market ‘Anomalies’

Forced selling may be distorting prices for secured bank loans. Senior bank loans that are higher up in the capital structure of a bank, meaning owners of the bonds would be paid before other debtors in the event of a default, are trading at lower levels than junior portions of the structure, he said. That means safer loans are cheaper than their riskier counterparts.

“All these anomalies are part and parcel of the liquidation in the credit market,” Grant said.

“That’s why we’re bullish on credit, because so many things simply don’t add up.”

Grant is the founder of Grant’s Interest Rate Observer, a financial journal. He was a columnist for Barron’s before founding the Observer in 1983.