First, let's take one of those high-quality, non-cyclicals as an example: Johnson & Johnson. Its one of the few AAA-rated corporations left, and pharmas are about as non-cyclical as they get, so it should be a good example of "opportunities" in corporates. Here is the chart of the "spread" on a Johnson & Johnson bond maturing in 2013. The spread here is just the bond's yield less the rate on a corresponding Treasury. Higher spreads mean a greater income differential compared with credit risk-free bonds.
JNJ's spread is well off its high in November, but still much wider than its been in recent years. So yes, in spread terms it looks like a great opportunity.
But is spread the relevant measure for you? If you hedge out interest rate risk, then yes, it is. If you are a relative value portfolio manager, then yes, it is. If you are an investor who must be invested in the bond market, then yes, it is. But for a lot of investors, its a question of yield not yield spread.
So here is the graph of both yield spread and absolute yield.
Suddenly the great opportunity doesn't seem so great! The fact is that ultra-high quality corporate bonds only look attractive when compared to Treasuries and Agency bonds. For some investors who are living off their portfolio income or are legally bound to the bond market, JNJ is probably a good alternative to ridiculously low Treasury rates. But for those holding on to cash waiting for market conditions to improve, these corporate bonds are a trap.
That's because as global economics improves (thus allowing corporate bond spreads to tighten), it is likely that inflation becomes a major problem. All the stimulus currently being thrown at the economy may be the right policy for now, but it will come with an inflationary cost at some point in the future. When this happens, Treasury rates will rise rapidly. I grant that corporate bond spreads will tighten in such a scenario, but the tightening will probably be overwhelmed by the rise in Treasury rates.
Next, consider the corporate bond market generally. Right now the average yield on a corporate bond, according to Merrill Lynch's index, is 7.64%. That's off the 9%+ that was available in late October, but still, easily higher than has typically been available this decade, either in absolute or spread terms.
Of course, the devil is in the details. Take a look at this histogram of yields within the corporate bond universe, using Merrill Lynch's corporate bond master as the source. It shows the percentage of total bond issues that are currently at a given yield range.
Notice that while the average yield is 7.64%, there is a very wide range. About 1/4 of corporate bonds currently yield 6% or less. Not too exiting. While 1/4 yield 10% or more. Compare this with a similar histogram from the hey-day of corporate bond liquidity, 12/31/2005.
Back then virtually all investment-grade companies carried yields within a narrow range, meaning that it didn't make much difference which corporate bond you owned. Few investment-grade companies were seen as having imminent default risk.
Today, many companies are seen as having rapidly declining credit quality, or at least the risk that credit quality could rapidly decline. Its probable that most of the companies yielding 10% or more will still be around, paying debt service, five years from now. So yes, there are likely some great trades in this group.
But none of these companies are easy trades. Its names like Simon Property Group, International Paper, Alcoa, Macys, US Steel, that are offering the juicy yields. Companies that are right in the teeth of this recession.
So what does the corporate bond market offer? For those who want to just collect income, corporates are a much better choice than either Treasuries or Agency bonds. There are enough solid names to build a diversified portfolio. But this trade is all about the income collection, or the carry. It isn't about making a great trade.
Or its about making the right credit call at the right time. Picking the beaten up name than can recover. But in that case, it isn't an easy trade, its a gutsy call that could wind up with a big capital gain or else a large loss in bankruptcy.
(No positions in any of these companies)
You forgot one HUGE element... inflation (or the lack thereof). At current breakeven inflation levels, real yields have increased dramatically and these breakeven levels can be taken advantage of rather easily through swaps, or even Treasuries if scared of counter-party exposure (long TIPS / short Treasuries).
ReplyDeleteThe example you use is a Johnson & Johnson bond maturing in 2013. You write " global economics improves global economics improves ". This argument assumes that the global economy will start growing before the bonds matures, which is a probable but not certain scenario. I have written elsewhere that we may need to reset our inflation and nominal return expectations as a result of the magnitude of the crisis. Certainly the citizens of Iceland will not forget 2008 for a very long time.
ReplyDeleteBesides low yields, inflation concerns, potential defaults or dilutions, bond buyers should also be concerned that there is a missing part in the demand equation.
ReplyDeleteDe-risking in the financial system will not be good for these corporate bonds. There was a time when some institutions bought these securities yielding less than 100 bps spread and levered 1 to 30 to get annual returns up to 30%. No more! Even modest 10% return targets would not be achieved with such spreads under new leverage restrictions.
AI - thank you! - Finally someone else gets the joke! All the talking heads (of which I am one unfortunately) are saying corporate bonds are the buy of the century. Your spread over yield argument is one I trot out every day to clients with the response (oh yeah!) mostly. The other one that worries me is when they talk about LQD or JNK Bond ETFs as a great way to play this!!!! Again these are yield based and if you think that Treasuries stay here for more than 10 mins then think again...We are pushing long LQD, Short TLH if u really want to get long corporate risk but otherwise, know your trade! Thanks again for ringiong the bells on this one.
ReplyDeleteI cant believe that JNJ 2013 YTM is 2.5%.... What a weird world we live in....
ReplyDelete..............
AI thanks for putting this write up together. Very helpful...
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Jake:
ReplyDeleteI did mention inflation.
Avant:
If you hold to maturity, then its a carry play, not a capital appreciation play.
Volkan:
Agreed. I've talked about this several times in the past. Lack of leverage changes the basic equation of bond arbitrage.
Credit:
I think a big part of the problem is that the talking heads are mostly versus index managers. Which is fine, but for many investors index returns don't matter. If the Barc Agg returns -4% next year and I do -2%, I'm lauded. But for many investors, its not really accomplishing anything.
Great post, AI.
ReplyDeleteI also have been looking at corporate bonds and also select preferred shares as places for yield.
I think one other market factor that you are alluding to but not explicitly stating is the discrimmination by industry. Big Pharma yields deserve to be very low in this environment because their main trading counterparty is government insurance (Medicaid, Medicare, etc).
One well seasoned preferred issue I have been big on is XFR. BMY balance sheet is solid, and their income is generally sustainable. Just an idea.
I have lost all enthusiasm for munis.
ReplyDeletehttp://www.cbpp.org/9-8-08sfp.htm
In Debt...
ReplyDeleteI tend to agree with you. In fact I will take it a step further and say that I would take a very deep breath before buying any government debt (other than short term) right now, including Federal. I think there are a lot of factors out there that are pointing to a spike in yields over the next 12- 24 months.
Anyone looking at munis should keep their powder dry for now.