Scratching My Head Till it Bleeds & The 5 classes of Corporate Bonds

by Peter Tchir, TF Market Advisors

The market has rallied more than 2% since the lows on Friday morning.  The rally has been almost exclusively central bank and government driven.

On Friday the rally started with rumors of ECB bond purchases, it continued Monday morning with Merkel softening her stance on how much Germany is willing to risk, and momentum accelerated to a crescendo once Bernanke made it clear that not only is QE not off the table, but he is dying to do more QE ASAP.

Equities seem to have completely accepted that central banks and governments can only be good for the market.  That is what has me scratching my head so hard.  Does nothing other than central bank policy make a difference?  Anyone who nailed the economic data last week has to feel like an idiot. The Chinese landing question has not been answered, but there is growing evidence that it could be the hard sort.  The European economy deteriorated and some of the weaker countries did the worst – Spain as a not so shining example.  Housing data in the US missed across the board, and generally the data was weak.  Yet here we are, back to new highs in equities.

So it is true that flooding the world with money has helped stocks, there have also been periods where stocks did poorly in spite of all these programs being in place.  Are we now supposed to believe that we can never go down again while central bankers are at work? That doesn’t match with history, yet yesterday seems to have convinced many that the only direction for stocks is up with Bendraghi in charge.  The S&P is trading at 14.7x earnings.  Maybe not overvalued, but also hard to argue that they are extremely cheap – especially with economic indicators not only a little weaker than expected, but showing signs that a lot of the strong data early this year truly was a function of weather, and rather than being able to jumpstart the economy, merely pulled activity forward and we are now seeing the impact of that.

While equities and commodities (except for natural gas) knew exactly what to do with the Ben’s statement, treasuries had more difficulty figuring it out. They seemed to be left scratching their heads and were torn between the desire to rally on the back of more government support, or selling off as part of a “risk on” rally.  Treasuries seem to be caught in no man’s land.  Fed purchases keep them artificially low, but with any potential for stability in the world, any signs of inflation, and a stock market this high, it is hard to be an “investor” in treasuries here.  There is real fear that you do not want to be the one left holding treasuries once the QE game is over.  It is a bit surprising that Ben wasn’t able to do more for treasuries yesterday.  The long bond is actually 2 bps higher than it was on Friday.

Corporate bonds were okay.  Not as enthusiastic as stocks and commodities, but more excited by the prospects of additional QE than treasuries.  On the credit ETF side, it looks like most of the appreciation went into increasing the premium as the NAV didn’t move as quickly.

Mortgages should do best on any QE as it seems that will be the primary beneficiary.  In the meantime, corporate bonds seem to be 5 distinct assets classes:

Investment Grade Corporate: These are already trading tight, but should have little volatility.  I would want to own them on a hedged basis, if at all.  Nothing wrong with the bonds, but little upside left.

Financial Bonds: Bonds issued by banks still have the most spread and best chance of appreciation.  They also clearly have the most risk.  I prefer bonds of the biggest European banks (DB and SG), but would want to avoid or be short the banks that have used LTRO the most aggressively.

“Short Dated” HY Bonds: There are a lot of high coupon hy bonds trading to call dates within the next two years.  Normally these offer limited upside, but it might be worth buying some.  Retail investors seem to have their eyes on these bonds, and there is now at least one ETF specifically targeting these bonds.  There isn’t much value here, but retail is likely to drive these bonds up a couple points higher than institutional investors ever would – especially with the economy being stable.  Decent carry and real chance that retail chases these bonds higher than they should be.

“Story Credit” HY Bonds: These have rallied but still have some potential.  It really is a “close your eyes” and hope for the best at this stage as the downside is probably greater than the upside, but if you truly believe in QE and its ability to make things good, you are supposed to close your eyes and buy these.  Not a strategy I like right now as I believe that in spite of (or because of) all the government and central bank intervention we are a long way from having resolved anything.

“high quality non-callable” HY Bonds: These are potentially the most dangerous.  These are typically BB companies with bonds that have good call protection for at least 5 years.  Spreads are relatively tight, though have room to move tighter, but in spite of many articles saying that HY doesn’t move with rates, these will.  We are in a pretty unique situation in the credit markets.  Treasury yields are very low.  Spreads on these bonds are okay, and could tighten, but the yields are very low.  The ability for this class of bonds to rally in a rising rate environment is low.  On a spread basis, they could tighten as they should outperform treasuries, but they can still go down on price.  They will be squeezed out by BBB bonds in a rising rate environment.  The analysis of HY correlation to treasuries that I have seen is too simplistic.  The first two categories of hy bonds that I mention do not have much rate risk.  This category does.