The media and most investors have been focusing on the carnage in
the stock market, as the major market averages have plunged 50% or more
since the market top in October, 2007. However, the carnage in the non
Federal government bond market has been equally shocking.
The normally stable market for high quality corporate bonds was
rocked by defaults by blue chip issuers like Lehman Brothers. A
representative index of these bonds has declined nearly 11% this year, even
including the income generated.
Lower rated corporate debt has suffered even more. The Merrill
Lynch High Yield index has tumbled 32.7% this year (including income),
rivaling the beating taken by the S&P 500, down 41.2%, including the
reinvestment of dividends.
Even municipal bond investors have their tails between their legs.
The Bond Buyer Municipal Bond Index has declined 16.7% this year, even
including the interest paid out. Investors are frightened by news that such
large profile issuers like California may default amid record deficits and
tax revenues crimped by recessionary conditions.
As a result, fixed income investors have rushed into US Treasuries,
reasoning that the return of their principal was more important than the
return on their principal. Yields on these Treasuries have been driven down
to 50 year lows. Ninety day Treasury bills yield practically nothing,
0.05%, while 30 year Treasuries are at yields approaching 3%. Imagine
giving up the use of your money for 30 years at such a low rate of interest,
notwithstanding the inflation and currency debasement that will inevitably
occur over that period.
Equity investors have not embraced the new bargains among non
Federal Government bonds. While the yields and potential returns have
soared, equity investors fret that bonds are not in their equity benchmark
indexes, and may not deliver the bang to keep up if we see a quick
convincing recovery from our woes.
So, non Federal Governmental bonds are neglected by fixed income
investors, who see them as too risky, while equity investors see them as,
well, not equities. This dearth of buyers has created many opportunities in
fixed income that more flexible investors should consider.
Municipal Bonds
Traditionally, yields on the debt of states and political
subdivisions were lower than the debt of the US Government. After all, so
called municipal debt was free from Federal taxes and normally, if held by a
resident of the state where issued, state and local taxes, too. US
Government debt, on the other hand, is only free from state and local taxes.
However, amid the credit crunch investors have fled this paper, and
yields are at record high spreads to Treasuries. For example, the yield on
the Merrill Lynch Municipal index for maturities of 22 years or longer is
now at 6.88%, or as much as 3.83% more than 30 year Treasury debt. So, an
investor can not only receive greater income but also pay no taxes. A 6.88%
muni yield for an investor paying combined Federal and state taxes at the
40% marginal rate is a taxable equivalent yield of 11.47%. That's an equity
like return!
There's no question that risks are elevated in muni land. The State
of California is talking about paying its vendors in IOUs by March if
conditions don't improve. The Port Authority of New York and New Jersey
failed to receive any bids for a recent offering (although of taxable
notes). The liquidity of these bonds is not as good as Treasuries, although
buying the bonds through a mutual fund addresses that issue.
Nevertheless, given the generally stellar credit performance of
these bonds over the decades, including during the 1930s, these juicy yields
appear to compensate for the risk. Favor general obligation bonds, which
are backed by the taxing power of the issuer, or revenue bonds supported by
critical infrastructure projects, like sewers or water. If muni bonds
recover their 2008 losses in 2009, investors will enjoy equity like returns
with less risk than the equity markets.
High Quality Corporate Bonds
The flight from any sort of risk following the implosions of Lehman,
Washington Mutual and other financial institutions has left the debt of even
creditworthy stable corporations at bargain basement levels.
The yields are attractive both on an absolute basis and relative to
Treasury bonds of similar maturities. Yields on corporate bonds now average
8.6%. The extra yield on US corporate debt relative to Treasuries is
approximately 6.39%, according to Merrill Lynch indexes that track that
metric. Such a gulf has never been seen in the 12 years Merrill has made
those calculations.
Why the bargains? Investors fear a 1930s style economy, complete
with rising defaults among corporations. There is concern that financial
institutions have not completely written down their bad loans. Fear abounds
of more ratings agency downgrades, of more forced selling by hedge funds and
other institutions. Investors have lost faith in the rating agencies.
Could they be right? No one can rule any scenario out. However, we
do know that investors in corporate bonds are taking less risk. Corporate
bonds rank higher in the capital structure, meaning they have first claim on
the cash flow, and are thus senior to its equity. The income stream from
corporate bonds is typically higher than the dividends on the common stock,
thus reducing volatility. Failure to pay that income is a default leading
to bankruptcy; omission of a dividend payment is embarrassing, but is not of
the same magnitude. With corporate bonds, there is a stated maturity, a
date when the corporation promises to give you your money back.
With yields to maturity, meaning the current income plus the gain on
the principal from current levels to par at maturity, now reaching double
digit percentage levels, investors should incorporate this asset class into
their equity portfolios. Corporate bonds are best held in a tax sheltered
account, as bond income is taxed as ordinary income, incurring nearly twice
the tax burden imposed on most stock dividends.
Bonds are not as liquid as stocks. Smaller investors may be best
off buying their bonds in bundles, in other words using bond funds. This
provides instant diversification, and allows for relatively easy entrance
and exit.
Low Quality Corporate Bonds
These bonds, also known as high yield or junk bonds, have been the
most pummeled of all types of fixed income. Their yields are at levels
never seen before, now averaging 22.37% per Merrill Lynch. The margin of
that yield over Treasuries, close to 19%, has never been seen before. As
recently as June, 2007 that spread was just 2.68%!
Investors seem to be pricing in a rate of default that surpasses
even what was seen during the Great Depression. Even if these default rates
come to pass, investors could still receive a positive return on this asset
class due to the record low valuations and superior yields of the survivors.
The risks are legion, but like their high quality brethren, these
securities are safer than the underlying common stock of their issuers.
Their yields are higher, offering investors an extra measure of safety and
dampening volatility.
To minimize the risks of selecting the bad apple of the group,
invest in these securities via a fund. Fidelity's High Income Fund (SPHIX)
is down nearly 29% this year, and yields 14.5%. An exchange traded fund,
iShares iBoxx $ High Yield Corporate Bond Fund (HYG), yields nearly 13% and
it, too, is down over 29% year to date. For aggressive investors,
Prudential manages the closed end High Yield Income Fund (HYI). Down 38%
year to date, it trades at a 20% discount to the net asset value of its
diversified holdings, and yields 18.6%.
A recovery in the high yield market to just where it was at the
start of the year, even if it takes several years, would provide returns
rivaling the long run returns normally enjoyed in the stock market.
In sum, equity investors trying to navigate these markets should
consider any fixed income not issued by the US Treasury in their search for
superior returns with less risk.
By David G. Dietze, JD, CFA, CFP(tm)
President and Chief Investment Strategist
Point View Financial Services, Inc.
Visit our web site www.ptview.com
the stock market, as the major market averages have plunged 50% or more
since the market top in October, 2007. However, the carnage in the non
Federal government bond market has been equally shocking.
The normally stable market for high quality corporate bonds was
rocked by defaults by blue chip issuers like Lehman Brothers. A
representative index of these bonds has declined nearly 11% this year, even
including the income generated.
Lower rated corporate debt has suffered even more. The Merrill
Lynch High Yield index has tumbled 32.7% this year (including income),
rivaling the beating taken by the S&P 500, down 41.2%, including the
reinvestment of dividends.
Even municipal bond investors have their tails between their legs.
The Bond Buyer Municipal Bond Index has declined 16.7% this year, even
including the interest paid out. Investors are frightened by news that such
large profile issuers like California may default amid record deficits and
tax revenues crimped by recessionary conditions.
As a result, fixed income investors have rushed into US Treasuries,
reasoning that the return of their principal was more important than the
return on their principal. Yields on these Treasuries have been driven down
to 50 year lows. Ninety day Treasury bills yield practically nothing,
0.05%, while 30 year Treasuries are at yields approaching 3%. Imagine
giving up the use of your money for 30 years at such a low rate of interest,
notwithstanding the inflation and currency debasement that will inevitably
occur over that period.
Equity investors have not embraced the new bargains among non
Federal Government bonds. While the yields and potential returns have
soared, equity investors fret that bonds are not in their equity benchmark
indexes, and may not deliver the bang to keep up if we see a quick
convincing recovery from our woes.
So, non Federal Governmental bonds are neglected by fixed income
investors, who see them as too risky, while equity investors see them as,
well, not equities. This dearth of buyers has created many opportunities in
fixed income that more flexible investors should consider.
Municipal Bonds
Traditionally, yields on the debt of states and political
subdivisions were lower than the debt of the US Government. After all, so
called municipal debt was free from Federal taxes and normally, if held by a
resident of the state where issued, state and local taxes, too. US
Government debt, on the other hand, is only free from state and local taxes.
However, amid the credit crunch investors have fled this paper, and
yields are at record high spreads to Treasuries. For example, the yield on
the Merrill Lynch Municipal index for maturities of 22 years or longer is
now at 6.88%, or as much as 3.83% more than 30 year Treasury debt. So, an
investor can not only receive greater income but also pay no taxes. A 6.88%
muni yield for an investor paying combined Federal and state taxes at the
40% marginal rate is a taxable equivalent yield of 11.47%. That's an equity
like return!
There's no question that risks are elevated in muni land. The State
of California is talking about paying its vendors in IOUs by March if
conditions don't improve. The Port Authority of New York and New Jersey
failed to receive any bids for a recent offering (although of taxable
notes). The liquidity of these bonds is not as good as Treasuries, although
buying the bonds through a mutual fund addresses that issue.
Nevertheless, given the generally stellar credit performance of
these bonds over the decades, including during the 1930s, these juicy yields
appear to compensate for the risk. Favor general obligation bonds, which
are backed by the taxing power of the issuer, or revenue bonds supported by
critical infrastructure projects, like sewers or water. If muni bonds
recover their 2008 losses in 2009, investors will enjoy equity like returns
with less risk than the equity markets.
High Quality Corporate Bonds
The flight from any sort of risk following the implosions of Lehman,
Washington Mutual and other financial institutions has left the debt of even
creditworthy stable corporations at bargain basement levels.
The yields are attractive both on an absolute basis and relative to
Treasury bonds of similar maturities. Yields on corporate bonds now average
8.6%. The extra yield on US corporate debt relative to Treasuries is
approximately 6.39%, according to Merrill Lynch indexes that track that
metric. Such a gulf has never been seen in the 12 years Merrill has made
those calculations.
Why the bargains? Investors fear a 1930s style economy, complete
with rising defaults among corporations. There is concern that financial
institutions have not completely written down their bad loans. Fear abounds
of more ratings agency downgrades, of more forced selling by hedge funds and
other institutions. Investors have lost faith in the rating agencies.
Could they be right? No one can rule any scenario out. However, we
do know that investors in corporate bonds are taking less risk. Corporate
bonds rank higher in the capital structure, meaning they have first claim on
the cash flow, and are thus senior to its equity. The income stream from
corporate bonds is typically higher than the dividends on the common stock,
thus reducing volatility. Failure to pay that income is a default leading
to bankruptcy; omission of a dividend payment is embarrassing, but is not of
the same magnitude. With corporate bonds, there is a stated maturity, a
date when the corporation promises to give you your money back.
With yields to maturity, meaning the current income plus the gain on
the principal from current levels to par at maturity, now reaching double
digit percentage levels, investors should incorporate this asset class into
their equity portfolios. Corporate bonds are best held in a tax sheltered
account, as bond income is taxed as ordinary income, incurring nearly twice
the tax burden imposed on most stock dividends.
Bonds are not as liquid as stocks. Smaller investors may be best
off buying their bonds in bundles, in other words using bond funds. This
provides instant diversification, and allows for relatively easy entrance
and exit.
Low Quality Corporate Bonds
These bonds, also known as high yield or junk bonds, have been the
most pummeled of all types of fixed income. Their yields are at levels
never seen before, now averaging 22.37% per Merrill Lynch. The margin of
that yield over Treasuries, close to 19%, has never been seen before. As
recently as June, 2007 that spread was just 2.68%!
Investors seem to be pricing in a rate of default that surpasses
even what was seen during the Great Depression. Even if these default rates
come to pass, investors could still receive a positive return on this asset
class due to the record low valuations and superior yields of the survivors.
The risks are legion, but like their high quality brethren, these
securities are safer than the underlying common stock of their issuers.
Their yields are higher, offering investors an extra measure of safety and
dampening volatility.
To minimize the risks of selecting the bad apple of the group,
invest in these securities via a fund. Fidelity's High Income Fund (SPHIX)
is down nearly 29% this year, and yields 14.5%. An exchange traded fund,
iShares iBoxx $ High Yield Corporate Bond Fund (HYG), yields nearly 13% and
it, too, is down over 29% year to date. For aggressive investors,
Prudential manages the closed end High Yield Income Fund (HYI). Down 38%
year to date, it trades at a 20% discount to the net asset value of its
diversified holdings, and yields 18.6%.
A recovery in the high yield market to just where it was at the
start of the year, even if it takes several years, would provide returns
rivaling the long run returns normally enjoyed in the stock market.
In sum, equity investors trying to navigate these markets should
consider any fixed income not issued by the US Treasury in their search for
superior returns with less risk.
By David G. Dietze, JD, CFA, CFP(tm)
President and Chief Investment Strategist
Point View Financial Services, Inc.
Visit our web site www.ptview.com
