How many red faces in the bond crowd? Long Treasuries were supposed to zip up to a 4.5% yield with 10-year paper at 3.5%. Bunches of "smart" money shorted 30-year Treasuries with impunity. What happened, fellas?
The bull run in fixed income is easy to explain. So far, the economy limps along. Retailers like Wal-Mart post sluggish numbers and capital goods activity doesn't kick in. So, we've got a depressed GDP sector along with negative exports. The Fed still tells everyone who can read that deflation is the serious issue for the country as well as unemployment.
Everyone waits for home starts to recover but they don't, despite attractive terms on 30-year mortgages, below 4.25%. Historically, this is a bargain. Yes, home prices have risen substantively but so have rentals. I find the rental-to-buy ratio for housing a peripheral coincident indicator.
For better or worse, the history of interest rates during the entire postwar period is etched into my brain. There is no normal rate for the country. Treasuries key off budget deficits, inflation, the growth rate for GDP and trade surpluses or deficits.
The bond crowd forever is hypersensitive to any change in these variables. It can riffle into new alignment in a month or two, with volatility equivalent to a 10% move in the S&P 500, up or down. Treasuries with long duration levitated 10% year-to-date.
Does anyone but me remember when Federal agency 5-year notes yielded 15% in 1982? I'm a prisoner of apperceptive mass on Treasuries going back 60 years. The trendline for 10-year and 30-year paper ranges around 5%. For LIBOR we are talking nearly 4%, not next to zero.
I'd chance equities rather than inventory Treasuries so far below historic trendlines. Yield disparity between 10-year Treasuries and BB corporates stands under 300 basis points, down from 500 a couple of years ago.
The high yield bond sector contains all the prisoners of yield starvation who have given in. To hell with all this yield compression. We need income. Let's buy some low rated corporate bank debt packages, too. After all, they yield 4% and are a play on rising LIBOR somewhere lurking in the bushes.
Such rationalization invariably comes home to roost, uncomfortably. I'm inventorying over a dozen preferred stocks selling at or below their $25 call price and yielding 6.5%. The problem is almost all preferred stocks are issued by financial houses – banks, brokers and insurance underwriters. They're all below investment grade.
In the financial meltdown of 2008 – '09, Bank of America's Bank of America's preferreds touched down at $5 a share. They became one decision pieces of paper. If the bank stayed in business the paper was golden, destined to tick at $25, the current quote.
But, anyone who looks at preferred stocks other than pure equity is due for an unpleasant surprise sooner or later. Consider that Fannie Mae Fannie Mae defaulted on its huge issue of preferred stock during the banking crisis. Much of this paper was held by institutions in their pension funds.
If the U.S. Treasury had allowed a default on federal agency paper, losses would have run into trillions, literally decimating institutional portfolios, creating gut wrenching actuarial issues for pension funds in corporate, state and municipal sectors.
Even now, trouble is brewing in New Jersey, New York City and possibly New York State. Governors and mayors all across the country thirst to defer pension fund allocations for years ahead. Governor Cuomo posts IOU's into his state funds. New Jersey is deferring past due funding while Mayor de Blasio has agreed to contract settlements with the teachers union that cost the city billions next couple of years.
The rally in municipal paper, especially New York State and New York City issues, reflects the financial health of the stock market and earnings for Wall Street's banks and brokerage houses, a cyclical phenomenon. How long can the state and city live off capital gains taxes posted by the top 1%? Some AA, 20-year maturities I hold have risen over 20%, past couple of years. Enough is enough!
I never expected the latest surge in yield flattening. Yes, the Fed has disenfranchised savers who earn zilch on money market funds. The flight into the dollar goes on. Where can the Chinese go with their export earnings? If Germany sets the example we could see 10-year Treasuries at a 1% yield. Even poor Greece which was unbankable 4 years ago, floated 5-year paper yielding 4.75%, the deal wildly oversubscribed. Our 5-year paper yields 0.7%, practically confiscatory.
The bull market case for the fixed income sector is too much invested capital still seeks a home there. Pension funds fear putting the lion's share of cash flow into equities. This is understandable considering everyone is using unrealistically high discount rates on pension fund obligations.
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