Long Junk (Ishares High Yield Bond ETF, HYG) at 88.91 Short 10y Treasury (Ishares Lehman 7-10 TR Treas. ETF, IEF) at 99.18

Long Junk (Ishares High Yield Bond ETF, HYG) @ 88.
91
Short 10y Treasury (Ishares Lehman 7-10 Tr Treas. ETF, IEF) @ 99.18
The double dip been averted….
It is difficult to pick up a newspaper in the last few days without this new consensus view after the
FEDs inaction in September. The “FEDspeak” reassures that with a continuation of softening numbers
they will have to intervene once again with QE 2.0. GDP growth in Q3 was promising, but as David
Berman of Gluskin Sheff points out, the largest driver in that growth was a 30% surge in auto
production, mostly thanks to the news of a GM IPO. The glut of auto activity added 1 ½ percentage
points to headline growth…Hardly the sturdy recovery bulls are looking for. The most recent
Consumer Confidence index number, down 4.7 points, does not imbue strength either. (See
“Consumer Confidence Index” in Appendix) It appears the “aberration-like” August numbers, and
2010 numbers, for M&A have head -faked investors to put risk on once again.
Despite massive media bond promotion, and warning about stalled US growth, high yield corporate
debt, investment grade and Treasuries have only returned 6.5%, 4.9% and 2.7%, respectively, last
quarter. This doesn’t seem bad for fixed income, until you realize this was a quarter where US
individual investors moved $87.7 billion into total bond funds, the most ever. (See “US Mutual Fund
Flows” for comparison) With minimal returns, massive inflows from individual investors (who are
traditionally late to the party), and yields on 10 yr Treasury touching all time low of 2.5%, I believe
most of the juice has been squeezed out of low risk fixed income. Bonds are priced for a Japan style
era depression according to these yields, and while I am not outright bullish on the overall economy for
reasons stated above, I have put a very low probability (15%) on a subsequent dip and flight to safety.
Under current market conditions I would like to own top of capital structure bonds (junk) where I can
take advantage of both over-exaggerated depression ailments, and potential economy rebound, while
still holding some protection (over equity) against a large move in markets.
Fool me once…And I’m too scared to be fooled again
The importance to hold investment grade, after being burned by rating agencies in 2006 crisis, is fresh
in investors’ minds and as a result, junk debt has been neglected. In a record setting issuance quarter
of $190b, supply has outpaced demand significantly, resulting in appealing prices. While the spread
between junk and treasury yields has tightened to 6.29 percentage points, this spread has been
historically lower, with an average of around 5 percentage points, and a low of 2 percentage points in
2007. (See “Bonds Roll On” in Appendix) According to NY Times, these prices imply a 6% default rate
over the next 12 months for junk bond issuers, which is significantly higher than Moody’s projection of
3%. The passage of Obama’s small business aid package also stands to help provide tax incentive and
aid for smaller companies.
Maybe it is a bubble after all
The short Treasury position not only hedges interest rate exposure, but also provides an opportunity to
bet against the massive bond fund inflows that I expect to subside should a dip not occur. Investors
will require a greater return on their capital than offered in Treasury rates and I expect them to reach
for yield in risky assets as the painful memory of 2007 subsides. This should result in a gradual
deflation of the “bond bubble” and for rates to eventually move back toward long-term averages. As
my former employer, Jeremy Grantham routinely says, “bubble investing is the one constant in the
markets, it’s not about if it will pop, it is about when.” As shown in the appendix, the yield on 10 yr
treasury has crossed into “bubble territory” being 2 standard deviations away from the long-term
average. (In this case, long term average used is from 1/1/1990- present)
Risks
Political Exposure: If Republicans have a strong midterm, expect belt tightening and concentration on
austerity. Should the economy need further help, austerity will likely result in the inability for future
economic stimulation, potentially leaving the US in a prolonged recession with continued deleveraging
and falling prices. The expiry of Bush’s tax cuts for individuals and potential increase in corporation tax
will also play a large role in the performance of junk bonds.
FED Exposure: As discussed earlier, the FED has clearly reminded markets that should the economy
need support, it will be provided. The worry in particular is the POMOs, as the FED has been
purchasing medium term debt with the proceeds from agency debt and mortgage-backed securities
previously purchased. This sustained and large purchaser could singlehandedly keep rates low until
necessary.
-Mark Matthew Froot

Appendix:
Sources: Google Finance

Sources : Conference Board
Note : Graph data up to September 2010.

Sources : ICI
Sources : NYTimes
Sources : US Treasury

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Long Junk (Ishares High Yield Bond ETF, HYG) @ 88.

The double dip been averted….

Fool me once…And I’m too scared to be fooled again

Maybe it is a bubble after all

-Mark Matthew Froot

Sources: Google Finance

Note : Graph data up to September 2010.

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