This article by Richard M. Todd was recently published in the Denver Business Journal, Volume 59, Number 41, March 28, 2008-April 3, 2008, (Denver Business Journal). A reprint of the article may be found at the Innovest Website (Reprint).
The markets have continued their slides, and there's lots of negative data.
- Consumer prices made their largest rise in 19 months, and inflation expectations have risen to 3.7 percent in the next year, according to a University of Michigan survey.
- Job growth came to a screeching halt as the U.S. economy lost 63,000 jobs in February.
- The Consumer Confidence Index dropped to its lowest level since 1992.
- Housing remained weak in January, with foreclosures up 57 percent year over year.
Normally, one would think that bonds would benefit from this economic stall, and Treasury prices have risen with that expectation.
However, parts of the bond market have been bit hard by the rolling sequence of deleveraging. Investors have become frightened of leverage and lack of transparency. Yield spreads over Treasuries have gapped open, and consequently, some interesting opportunities will result for investors.
- Municipal bonds -- Yields have soared to historically high levels compared with U.S. Treasury bonds. Tax-free municipal yields normally trade at about 80 percent of taxable Treasury market yields. However, recent turmoil in the market has pushed municipal bond yields to an unprecedented 125 percent of Treasury yields.
The problem began not with the bonds and the underlying municipalities, but with the insurance companies that guarantee the bonds.
Insurance coverage by companies such as MBIA and Ambac were supposed to ensure that the bonds would be safe. Historically, a AAA rating always was given to insured bonds.
However, these insurers are reeling as their secondary line of business, insuring exotic mortgages, has been crushed, heavily weighing on their financial condition.
Problems came to the forefront last month when the funding of $330 billion in short-term municipal market paper was thrown into disarray. The auction failed due to lack of interest from dealers, big banks and brokers, which have their own balance-sheet problems. This lack of liquidity left corporate treasurers and wealthy private investors, who buy this debt as cash equivalents, unable to access their money.
Many argue that historical municipal bond defaults are so low that insurance isn't needed. Notable investors such as Bill Gross and Warren Buffet recently stated that municipals are at an historic buying opportunity.
- Mortgages -- Mortgage asset prices are tumbling partly because investors are borrowing less, as banks rein in both how much they lend and how much they borrow. As a consequence, AAA-rated, agency-backed Fannie Mae and Freddie Mac mortgages are yielding around 2.25 percent over 10-year Treasuries, the largest spread since 1986. AAA non-agency bonds are trading at about 70 percent of par, again a symptom of the lack of buyers.
Investing in this market isn't for the faint of heart.
There has been panic in the market, credit standards have been increased and deleveraging has been an anchor. The Fed wants a loose money environment and has pushed short-term rates down aggressively.
However, looseness doesn't occur unless lenders make loans. The Fed has started a collateral swap program to sell Treasuries and buy mortgages, a move that should improve liquidity and bring normality to the mortgage market.
- Bank loans -- Floating-rate secured, leveraged loans have been battered in the current credit crunch as well.
The recent risk-aversion contagion along with record loan supply has caused loan market prices to drop on average from slightly above par to below 90 cents on the dollar. Experts say that this cushion will absorb credit defaults caused by a recession and that this is priced into the market.
Historically, only 5 percent of loans go into default, and investors in defaulted senior debt typically recover about 75 cents on the dollar. The floating rate nature of bank loans could be an added bonus, protecting value in the event of inflation and the eventual rise of interest rates.
- High-yield bonds -- High-yield (or junk) bonds, which many consider more of an equity surrogate, may be an opportunity as well. Their yield spreads over Treasuries are currently more than 800 basis points, up from around 250 basis points just six months ago.
These bonds started the year with two consecutive negative months of performance, which has happened only one other time. Again, like bank loans, significant defaults are priced in the market, and the high yields offered in a diversified portfolio could be an opportunity.
In summary, although the bad news may not be all behind us, much is priced into these markets. Selective investments are offering attractive yields and/or yield spreads, signaling a potential opportunity for those investors in search of income.