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How the Bond Markets React 01.10.06
Flush with Cash
The Federal Open Market Committee (FOMC) has been raising rates steadily over the past year. Inflation, the primary target in this tightening has been moving around very close to their ceiling (which is assumed to be 2%). That could easily mean that they will continue to tighten the overnight rate until it hits 5%.
The Bernanke effect is still unknown. Although he looks to be at first glance to be an inflation hawk, his leadership of the committee after Greenspan's long tenure is open to speculation. Given some of the recent transparency, a look at the inner mindset that was not available just a few years ago, fixed income investors have begun to fall into two distinct and separate camps.
If you believe that the tightening will continue, you can also believe that the reward for risk will not be there either. The 10-year Treasury has been at or near where it was a year ago leading to the so-called flattening of the yield curve. Pensions and Asian investors continue to buy this security keeping. With core inflation remaining somewhat tame, the yield on the 10-year Treasury is very close to where it was a year ago.
The other camp believes that as soon as the tightening is over and they expect it will be soon, the Fed will reverse itself and begin easing. Unfortunately, the norm hasn't been so normal.
The expected "soft patch" caused by the rate hikes, now at 4.25%, up from 1%, has not happened. Is it possible that historic reactions are any indication of what the future holds for an economy that seems to be doing well - at least on the surface and mostly from a corporate standpoint.
It should also be kept in mind that the euphoria following the release of the F.O.M.C. minutes from their December meeting means nothing. The new Fed chief was not invited to that event.
Does the average corporate bondholder understand the result of the large amount of mergers and acquisitions or even leveraged buyouts (LBO)? Do they understand the implications on the credit quality of companies who have so much cash that share buybacks and special dividends? Not likely.
The average corporate bond investor - and hopefully they are using a bond fund - has been sort of blind sided by these events and 2006 looks to be ripe with challenges for the fixed income investor.
The result of these shareholder friendly actions has been a blow to credit ratings, the driving force behind prices and yield - which work in opposites with prices falling as yields increase.
An equity friendly environment, one where companies turn their backs on creditors has created the smallest spread for bondholders in over a decade. To understand what this means, we should first look at reward and risk. In the world of fixed income, reward comes in the spread. A spread is the distance between the bond offering and comparable Treasuries. When that narrows, creditors or bondholders are paid less for the money they allow companies to borrow. Risk equals leverage which is the ability to pressure a company to pay higher yields because the company needs the money and has nowhere else to turn.
The yield being paid to these bondholders has fallen as the spreads tighten and you would expect these investors to look elsewhere for the yield they seek. So far, that hasn't happened. Is this a sign that they believe the current environment will change soon? Possibly, but until something happens and credit ratings for this group improve, the corporate bond group still has the best reward for risk available.
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