Understanding Current Bond Market Turmoil

I don’t want to belabor this point, but since the mass media, print, TV and otherwise, keeps on it, it needs to be addressed. For years now, investors, fueled by an overly accommodative Fed, acted as if risk, particularly credit risk, didn’t exist or could be insured away. Hedge funds and dealer prop desks, using generous amounts of leverage, hired quants to develop complicated models that increase the speed and efficiency of executing a specific strategy. The problem is the models generally don’t work when markets become nervous and people don’t want to bid on securities (I would refer you to 1998 and Long-Term Capital for a more in-depth discussion). Over the past month (yes, it has been just a month), the investing world has reawakened to the concept of risk, especially credit risk.

Judging by the reaction, it would be thought that many people had never heard of it before this period (perhaps that is true). The reaction is to this is to completely avoid credit risk, therefore US Treasuries and the sovereign debt of other developed countries are the flavor of the month, so to speak. Other high-quality assets, ones with a small amount of credit risk, have treaded water. Citi brought a 5yr bond yesterday, their 4th offering this month, at +122, an almost unheard of spread for a company of that quality. However, if the 70 to 80 basis point rally in the 5yr Treasury over the past month is taken into account and subtracted, the spread is more like 40 to 50 off. The point here is that coupon Treasuries and Treasury bills have rallied on the flight to quality. The high quality credit risks out there have remained stable, just their spread relationship to benchmarks (Treasuries) have blown out. Even items with considerable credit risk, such as Brazil 10yr debt, are only 12 basis points higher in yield now than 1 month ago.

It is the bonds that are more difficult to value, sub prime, high yield, structured notes, anything that derives its value from something in an out of favor space, is being punished an rightfully so. Remember the pendulum analogy; markets, like a pendulum, overreact one way or another before coming back to a more normal level. This does create opportunities and anomalies. If you think that the Fed is bringing rates down, then this high quality corporate paper is a tremendous value as the market experienced the spread widening in a relatively short period. It probably won’t tighten as fast, but if you are a long term investor, this is one of the better entry points we’ve seen in years, particularly in preferreds.