Yield Spread Schizophrenia

Amid all the panic and gloom of the holiday season there’s actually some news out there that’s worth looking at.  No, not the next dip in the automaker-fed tango, nor the punch-it-up, self-absorbed gab surrounding the Madoff blow-up.  We couldn’t give a puckered cherry about either.

The real news these days is happening under the radar, in the bond market, where peculiar pressures are sending confusing messages to traders and investors alike.

Powerful Fund Flows To Treasuries

It’s no secret that the global flight to quality that took place over the last several months landed hundreds of billions of new dollars in the treasury market, where yields have been driven literally to nothing and are priced for a worst case deflation scenario.

It’s also no secret that this happened because at the height of panic everyone rushes to cozy up to the biggest, most secure daddy they can find.  And for all their so-called failings and flailings and double takes and turnarounds – there is simply no one else on the planet that inspires as much confidence as Papas Paulson and Bernanke.  And the fact remains that the press’s howlings over their incompetence has failed completely to stanch that flow of funds that’s currently seeking a secure home in the laps of these two handsomely paid gentlemen. 

The screaming may yet rise to a pinnacle pitch, but at day’s end everyone runs to America and the dollar – not the Rupee or the Pound or the Peso – to find money comfort.

I’m a Steamroller, Baby

And it seems that run is far from over.  If at the short end of the curve the result has been a drop to zero interest, the race to capture yield is now rolling its way out to longer treasury issues.  Those same foreign nationals, and not a few fund managers, are looking to capture something for themselves, and, in the case of the latter, to achieve profitability.  As one fund manager so aptly put it:

“…it’s hard to sit there and buy a bond that yields less than any fees you charge.”

The result?  An overhaul in the way short term, fixed income managers operate.

A Connoisseur’s Guide to Pancaking and Steamrolling

I’m indebted to the bloggers at the Wall Street Journal for initially tuning me in to this; and perhaps I can now return the favor by explaining to them what it all really means.

They referred to it as the “pancaking” of the yield curve, but it should more properly be termed “steamrolling” – for reasons we’ll presently explain.

First, a look at how exactly this “steamrolling” is taking place.

The Feds’ Goal

The Feds want nothing more than to get you and your rich aunt Daisy to start buying corporate securities.  But you won’t.  You’re scared, and however you justify it, you’d rather not go swimming when the water’s ice cold.  Fine.  But when you continue to beggar out the yield curve, happy to be thrown bones with nary a cheekful of meat on them, then you’ve no one to blame but yourself when you end up hungry and sick.

It’s people like you (and your rich aunt Daisy) and the money market and bond fund managers at the short end who’ve succeeded in driving both the 10 year note and the long bond to levels not seen since the mid 1950’s.  Last we checked, yields on the two were stationed at 2.12% and 2.56% respectively.

What this means is that the average bond investor is setting himself up for the whamdoggy of a lifetime, when the biggest – and maybe swiftest – backup in bond yields that New Rochelle has ever witnessed is activated.

It’s a major no-no at this late date to be putting money into treasuries.  The upside is so miniscule – particularly for short dated issues – that you might as well put a gun in your mouth and call it a day.  All the pressures in the pipeline are inflationary and the good Lord only knows what will finally trigger the selloff; but it will come, and when it does, it’ll be more of a tidal reckoning than a bushwhack.

As for the U.S. government, what could be better than the current scenario?  As lending rates are pushed to zero, government costs to refinance the debt are also reduced to zero.  Which is why all the bailouts and stopgaps and payoffs and TARPs and ZIRPs and KRAKs and SPITs of the last quarter will be (more) manageable than many expect.  But it’s incumbent on the treasury to start selling debt now to take advantage of that current reality.  Unless they do so, a great opportunity – perhaps the greatest – to refresh the American people’s balance sheet will have been squandered.

That they haven’t done so demonstrates their well placed fear that treasuries are mispriced, and that new issuance will only serve the process of (true) price discovery.  That is, that treasury yields will back up significantly and jeopardize aggregate lending levels.

A Constant, “Drifting” Yield Spread

As the zero yield phenomenon works its way further out the curve, one would expect corporate spreads to grow vis-à-vis treasuries; but strangely enough they’ve stopped.  The spread levels are roughly the same, with corporate yields coming down at approximately the same rate as treasuries.  The spread is “drifting” lower, so to speak.

This points to two salient conclusions:

1. That the credit market is mispriced at the corporate end for a lack of liquidity (which is now correcting), and

2. Mispriced at the treasury end due to faulty risk aversion (and getting faultier).

There’s absolutely no reason why corporates should be pricing in a 15% U.S. GDP contraction.  Equally, there is absolutely no reason to expect an acute deflation on the immediate American economic horizon.

Plainly put: corporate yield movement is offering a saner assessment of economic reality than treasury yield movement.

Bet on the corporates.  Particularly those that have been beaten red but still have solid businesses.  And do it with a fund that has collected some of the best of them under one roof: Loomis Sayles Bond Fund (LSBRX).

The Residual Income Report recommends immediate purchase of the Loomis Sayles Bond Fund (LSBRX) at $10.04 for a yield of 15.99%.

Because a steamroller moves.

Matt McAbby
Analyst, Residual Income Report