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How the Bond Markets React 05.18.05
High Hopes for High Yield
Even the most conservative of fixed income investors seeks some yield for their trouble. But the current market for bonds has become a truly troubling place, fraught with pitfalls and potholes known only to the pros. And even they seem befuddled at times.
With good reason, this bond market has slowly evolved into one that suggests long term commitments might be unrealistic - tying your money up in something as short term as a 10-year Treasury might force you to watch the rally pass you by while inflation picks up pace and growth slows; short term investments aren't offering enough risk for the effort as growth slows and inflation rises. So is there a place in the sun in high yield junk?
The junk market, offerings of debt from companies with higher than normal credit risk has been in a stupor of late, barely beating the spread. That spread is used by bond traders to determine the default rate. When the economy missteps or is expected to, companies who need money look to borrow it cheaply. As interest rates rise, the companies with the highest risk of default usually offer the highest yields. But they still need to do better than the spread.
Let me explain. The spread is calculated as the difference between the yield on the 90-day T Note and the 10-year Treasury month over month. Fixed income types look at the difference in yields of similar notes and use them to fix a high and a low and then they are able to fix a median. Suppose the difference in yield between the two notes one month was 200 basis points and the following month, for whatever reason, that had narrowed to 100 basis points - each 100 basis points represents a single percentage point, the median between their offered yields would be 150.
Based on that median point, which for the last twenty years has been 173, fixed income traders can determine whether there is trouble on the horizon. The spread is one of the best economic indicators. The Federal Reserve Board uses it. High yield investors pay attention to it as well because of the way high yield bonds are traded.
Basically, they are traded over the counter. The availability of these bonds during times when rates are rising falls because the market makers do not want to get caught with too many of the wrong priced bonds on hand. Without offerings, money to borrow becomes scarce and the market suffers.
Growth of the overall economy plays a roll in the high yield performance. When it slows, junk becomes considerably more risky because of the increased chance of default. Should growth slip below 3%, an already illiquid market dries up. Junk will then be truly junk, not worthy of your money.
Trying to decipher a strategy from these flat curves and rising interest rates is the stuff of pros. They can maneuver the treacherous waters that seem to be just ahead of us and accept whatever the market offers as better than nothing.
Equity investors however, should be aware that many businesses are using the short term junk market to pay dividends - despite being flush with cash. While earnings have begun to slip somewhat and expectations of future profits being revised downward, dividends have remained the same at most companies. Short of stock buybacks, luring investors in with cash incentives means borrowing to pay your shareholders. Dividends, even borrowing to pay for them, are now needed to keep investors interested. That should worry bond investors as well.
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