Convergence of Corporate and Treasury Yields Not What You Think

Many economy watchers are of the mind, simply so, that the market's appetite for risk is increasing, and others would like nothing more than to believe that this is yet another 'green shoot.'

Earlier this week we provided a note from Northern Trust's Paul Kasriel discussing the convergence of treasury yields versus corporate yields.

This combination of a rise in the Treasury bond yield, declines in yields on privately-issued bonds and rising stock prices is consistent with an asset allocation shift away from an asset with no credit risk to assets with credit risk. How can this lessen the chances of an economic recovery? If the current and increased supply of Treasury debt coming to market were “crowding out” private debt issuance, then the yields on privately-issued debt would be holding steady or rising in tandem with the rise in the Treasury bond yield. But again, yields on privately-issued debt are falling. In sum, investor risk appetite is returning, which is a good thing for the prospects of an economic recovery, not a bad thing.

Joe Wiesenthal, at ClusterStock believes that the convergence between government and corporate yields in absolute terms is due to the recognition that the bonds of large financial companies effectively carry the same government guarantees, only they've been far more attractively priced until recently.

Ordinarily, a shift of assets away from Treasury bonds toward privately-issued bonds signals a growing appetite for risk and yield, which might indicate either inflation fears or hopes or economic recovery. But the huge shift we’re seeing now (see the chart (above), and Northern Trust economist Paul Kasriel’s analysis this morning) might signal something else entirely: that the market is pricing in the implicit government guarantee of the debt of financial companies. So instead of a shift away from risk-free assets, we may be seeing a shift between different classes of risk free assets.

This isn’t just a theoretic possibility. It’s something that is actually on the minds of asset managers. As early as January, asset manager Eric Roseman was advocating purchasing the corporate bonds of financial companies on this very basis.

In fact, Bill Gross, the bond king, openly pointed this out earlier this year. In his May Outlook, Gross had the following to say vis-a-vis the future of investing:

Shaking hands with the new government is still the prescribed strategy, although it should be done at a senior level of the balance sheet.

But, even more relevant is that in an interview with Bloomberg' Kathleen Hays, February 10, 2009, Gross pointed out very specifically, and presciently, that their investment strategy was to 'shake hands with Uncle Sam.'

KH: All your themes lately have been, ‘go with the government,’ If the Fed’s buying treasuries, you’re not going to buy them too?

BG: Well, we wouldn't buy treasuries, but we would buy bonds that are correlated and related to treasuries with a higher yield.

KH: If even if the Fed starts this program of buying treasuries, which you said, hey, good idea, do it, you wouldn’t
buy treasuries, but you’d buy bonds correlated to them with higher yields. Let’s talk about corporate bond issuance which has really exploded recently. Why is that, and I know you have been recommending certain kinds of corporate bonds, holding them. Where do stand on that now?

BG: Sure, we’re recommending the higher tranche, the higher echelon of investment grade bonds, not necessarily Baa bonds, but single A, AA, and, in fact the bonds of the banks. Our motto is to shake hands with Uncle Sam. To the extent that the banks are supported, bank debt’s supported, those yields are in the 6-7-8% category, relative to 2-3% treasuries.

KH: I think you make a very good point. Right now, buy the corporate bonds, they’re safe, you get the yield, stay away from the equity, right? When does this stuff start working though? Wouldn’t that be a point when an investor could say, at some point when stocks bottom, you usually do get a bounce, a pretty good bounce that can carry you up high. How do you gauge that, I know you’re a bond fund, but nevertheless, then do you wish at times that you had a few equities? Will there be a point like that, when they’ll outperform?