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VIDEOIs This a Bond Bubble?
By
Peter Atwater
Aug 16, 2010 10:40 am
The fixed-income asset class continues to inflate.
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The first is price versus intrinsic value. In stocks that can be measured by P/Es and in housing by prices versus incomes, and normally one would measure this in terms of spreads versus Treasuries.
But currently the Treasury market -- and the short-term Fed Funds and mortgage markets for that matter -- are being "managed" by the Fed's aggressive monetary policy.
This makes it very difficult for investors (particularly retail investors) to determine what intrinsic value really is. (See also The Fed Declares War on America.)
Put simply, people are looking at the spread versus Treasuries without considering whether Treasuries are appropriately priced in the first place. In many ways, this reminds me of late 1999 when people measured PEs for a particular stock versus a 25 PE for the overall market; nobody questioned whether a PE of 25 made any sense in the first place.
The issue is further compounded by the psychological issues associated with earning "nothing.” And as retail investor bond ladders mature, people are losing a 4%-5% yield and looking to replace it. They can't accept 50 or 80 basis points as a "reasonable" return and the choice becomes whether to stretch in terms of maturity or credit risk, or both. (For more on investor psychology, see Taking Stock of the Stock Market.)
And to me this is why junk bonds are screaming right now. They are the only thing that "works."
Folks also forget that what defines a bubble is the use of proceeds and whether the funds are being used in an efficient or productive manner. Here I have two thoughts.
On the corporate side, we're not seeing investment; instead we're seeing the hoarding of cash. On a short-term basis, this seemed smart when there was no liquidity in the market but now we have seemingly unlimited liquidity -- but there's still no investment. Many people think that corporations will use their hoarded cash for investment or stock buybacks. I don't think so, at least not any time soon, given the "unusually uncertain" economic picture.
So what we have are corporations raising cash because they can (they're being all but begged to by the market) but they don't have a good use for it. To me this is epitomized by things like debt-for-debt swaps, which are always NPV negative (you pretty much have to all but seduce investors to give up a 5% yield) but can be "written off" by managers because these deals boost future EPS at the cost of a "one-time non-cash charge"...
But think about it; right now we have companies issuing bonds with no real use for the proceeds. Right now, all these cash piles seem "wise" but too much liquidity ultimately isn't a good thing, especially as I strongly doubt it will make its way into buybacks.
Companies are discovering every day how deflation and a low-rate environment destroy asset values and increase liabilities. The net takeaway is that companies will hoard both cash and capital, which, needless to say, isn't good news when it comes to PEs.
There's another element to all of this that I don't think anyone is really focused on and that's whether the Treasury market meets the definition of a bubble, at least as defined by whether the proceeds are being deployed in an efficient manner.
To me, the Federal Reserve's willingness to buy Treasuries, not to mention the flight to quality trade out of Europe, created a false sense of security for Washington as it relates to America's ability to issue more and more debt.
So to me, that is one side of the bubble definition -- too much money.
But do we have too much money chasing too little opportunity as well?
Beyond the standard private sector versus public sector debate on relative efficiency, I think one needs to assess whether our incremental deficits are funding "real sustainable growth" or are really just delaying hard choices. (For what it's worth, America is hardly alone at it relates to this issue.)
My concern right now is that we have a corporate credit bubble riding on top of a sovereign credit bubble. (Also read The Last Gasp Bubble of Government.com.) To date, many market pundits have suggested that stocks and corporate bonds can "decouple" from the sovereign credit issues.
To me that notion is pure folly.
The past three years have coupled sovereign credit and the financial services sector in an unprecedented manner and there's no way that the corporate sector is or can be decoupled from the banks.
Therefore whether the corporate sector wants it or not, its fate is tied to the government.
(Fixed-income ETFs include iShares Barclays 20+ Year Treas Bond (TLT), iShares Barclays 10-20 Year Treasury Bd (TLH), iShares S&P/Citi Intl Treasury Bond (IGOV), iShares Barclays 1-3 Year Treasury Bond (SHY), and SPDRs S&P 500 (SPY).)
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No positions in stocks mentioned.
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