Thursday, July 27, 2006

Jack and Jill went out the yield curve to fetch a little yield

The yield curve is inverted, right? Which means if you want to increase the yield of a bond portfolio, you should buy shorter bonds, right?

Not so fast. The Lehman 1-3 year Government/Credit index yields 5.29% as of last night, but the Lehman 5-10 year Government/Credit index yields 5.58%. How can this be? The fact is that the only yield curve that is inverted is the Treasury curve. Take a look at the following large issuers with large bond deals maturing in both 2-years and 10-years and an approximate yield available on each issue. Yields are based on quotes or trades I've seen that I think are accurate unless otherwise noted.

Treasury: 2-year - 5.03%, 10-year - 5.02%
Fannie Mae (non-call): 2-year - 5.33%, 10-year - 5.43%
General Electric (AAA/Aaa): 2-year - 5.46%, 10-year - 5.71%
Citigroup (Aa1/AA-): 2-year - 5.48%, 10-year - 5.83%
Target (A+/A2): 2-year - 5.48%, 10-year - 5.76%
Comcast (BBB+/Baa2): 2-year - 5.70%, 10-year - 6.40%
Generic 6% FNMA MBS: 15-year - 5.81%, 30-year - 6.19%
(Source: Bloomberg)
Generic Tax-Ex. Municipal (AAA/Aaa): 2-year - 3.69%, 10-year - 4.10%
(Source: Municipal Market Advisors)

Most money markets are in the 4.50% to 5.00% range, depending on how much in fees they are charging. Point being, you do get more yield by going out the yield curve in virtually all areas of the bond market. Why? Because most bonds have multiple types of risk, and those risks tend to increase as time to maturity increases.

Most obvious is credit risk. Obviously a company is more likely to default sometime in the next 10 years than sometime in the next 2 years. Analysts like to say we have more "visibility" about the near term compared with the long term. For example, we know that Comcast has a near monopolistic position in cable TV services in many of the regions it serves. They are using this position to make major in-roads in the high speed internet business. That is unlikely to change much over the next 2 years. In 10 years? TV technology will undoubtedly change over that time possibly in a way that severely harms Comcast's business.

The municipal yield curve is funny. It just refuses to invert. That's a subject for another post, though.