The Undead Economy

Recent economic data indicates that the economy is not quite dead. However, it is not quite alive either. Consumer spending picked up in August, but recent measures of consumer confidence indicate that consumers are remaining jittery. Home prices remain depressed and the existing neglected stock of homes decomposing in the field. The unemployment rate remains at a disturbing 9.1%, but that only counts people who applied for jobs during the past four weeks. The real unemployment / underemployment rate (the U6 report from the Labor Department) stands at 16.5%. Meanwhile policy makers point figures at one another and youthful protesters being encouraged by celebrities, who believe that they have earned their millions in a manner the deem to be respectable, to demonize people who have made large sums of money in other ways, and by political opportunists.


Meanwhile EU officials fiddle while Greece burns, but what the heck, the Greeks are fiddling faster than anyone. Defaults and hits to the banks are coming. Major capital raises and possible bank dividend cuts are coming. A European recession is on the way and emerging economies are beginning to slow. Unfortunately, the fiscal policy response has been embarrassingly poor. All we can come up with is tax the rich, more regulation, demonization and schemes to spend on big union infrastructure programs. It would be better to help boost the private sector by simplifying regulations and the tax code as well as changing forthcoming healthcare rules from an overreaching plan to ration care into a scheme to make care more affordable and therefore more available.

Meanwhile the Fed does what it can to keep money accessible and affordable. However, it cannot force firms and households to borrow and spend. The U.S economy will trudge along. This will have implications for the fixed income markets. Interest rate products (U.S. treasuries and Agency senior notes) will see yields fall. Some credit products, such as high grade bonds from the industrial, energy, telecom and utility sectors should see yields move lower with U.S. treasuries. However, high grade bank, finance and insurance bonds could see credit spreads widen and yields remain about where they are or even rise, somewhat. High yield is another story.

Higher benchmarks could mean higher yields in high grade corporate bonds. This could begin to pull investors up the credit quality scale. If sufficiently attractive returns are available in A-rated paper, investors may move up from BBB-rated bonds. BB investors may move to BBB and B and CCC investors may move to BB. The result could be significantly wider credit spreads for the very bottom of the high yield universe. Wider spreads and higher U.S. treasury benchmark yields could make it difficult, if not impossible for very-low-rated companies to refinance debt. As we said yesterday, the best risk versus reward values in high yield reside in BB-rated paper five years and shorter.

We have just experienced the best of the golden age for high yield debt. While there could be further upside for very-low-rated bonds in the near term, should the economy regain some traction while the Fed leaves policy very accommodative, your potential downside far outweighs your upside due to the current environment of low benchmark yields and relatively narrow credit spreads.

Although we have been vocal about the richness of the high yield markets for several months, we are not alone. Today’s Wall Street Journal “Credit Markets” column discusses high yield fund managers lightening up on their high yield corporate bond exposure:


“After riding a two-year rally in U.S. "junk" bonds, some high-yield bond-fund managers are looking elsewhere for returns.”
“Some fund managers said they are worried that U.S. companies selling below-investment-grade, or junk, bonds aren't compensating investors enough for the risk, especially as the economy slows. So, they are putting more money into other assets they consider better value and less risky, such as corporate debt in Europe or emerging markets, commercial mortgage-backed securities and convertible bonds.”
We would use caution when investing in the asset classes mentioned in the article (it is almost impossible for retail investors to invest in Commercial MBS) and European and EM debt are aggressive ideas, but even the fund managers believe that high yield corporates may be getting a little rich. Again, high yield bonds are most appropriate for aggressive investors and the best values on a risk versus reward basis tend to lie five years and in on the curve among BB-rated companies.

We have received questions regarding finding relative values in the preferred markets. Currently, preferreds are trading with tight spreads to bonds issued by respective companies. Investors may wish to consider swapping out of preferreds (which tend to have long maturities or are perpetual and are very subordinate on corporate capital structures) and consider purchasing bonds (particularly senior note, although there are attractive subordinate notes) in the 7-year to 15-year area of the curve. One can earn attractive returns, lower duration and, in most instances, climb several rungs on the capital structure.