Why Debt is Now the Best Proposition

Most market players, present company included, are faced daily with the choice of which asset class possesses the best risk/reward characteristics. Considering that I believe that earnings estimates for stocks in are at best, optimistic, or at worst, impossible to predict, this leads us to more “traditional” valuation measure like “Graham and Dodd” analysis or the “Tobin Q Ratio” (Market Value/Net Worth).

As you can see in the chart below, the market would need to be carved in half yet again to reach the secular bear lows of the early 1980”s, a number (S&P 400-500) that is actually my ultimate goal for this bear market before rallying back to 800 or so.

Tobin's Q for S&P 500


Click to enlarge

Got Debt?

While I have highlighted the over-leveraging of the world over the past 10 years or so, we do get to a point when markets fully price in bad news, or for that matter, overshoot to the upside or downside. I believe that long-term investors (folks that can actually withstand interim volatility) are now being properly compensated for taking credit risk.

Spreads could blow out further, but the yield along the way is an excellent proposition, particularly when compared to stocks.

Agency Mortgage Backed Securities in general are appearing to be a good risk/reward proposition based on an OAS (Option Adjusted Spread) basis, and even high-grade corporate bonds and yes, even junk bonds are a good proposition.

Please note: While my firm is a significant player in the MBS market, we have no position in corporate bonds, nor are we likely to in the near future. We are completely avoiding the preferred and hybrid (perpetual “fixed-to-floating) markets, as I wouldn't be stunned to see Uncle Sam tell banks and finance companies that they aren”t allowed to pay dividends in the not-too-distant future (let”s face it, banks are now socialized utilities).

Considering that nearly 90% of issuance has been in financials, I would stay away - in fact, very far away. Municipals are tempting, but lack liquidity; the housing crisis has yet to be completely felt in that arena, and I don't feel capable of doing credit research on the nearly 50,000 issuers with municipal debt outstanding.