by Umar Farooq
While stocks, as measured by the S&P 500 Index, are hovering near all-time highs, bond market prices, which typically move inversely to stock prices, instead moved higher with the 10-year Treasury yield dropping to 2.18% on April 18, 2017. Rates have crept higher since then, but the 10-year Treasury yield close of 2.32% on Monday, May 1 remains nearly 30 basis points lower than the year-to-date high of 2.61% reached on March 13, 2017. Higher bond prices, despite strong performance in the stock market, have many wondering which market has it right, stocks or bonds.
“U.S. companies have taken on an extra $7.8 trillion of debt and other liabilities since 2010, according to the International Monetary Fund. Strip out the boom-to-bust energy sector and median corporate leverage is the highest since at least 1980. But the signs that the credit markets may be starting to get carried away are more in the structure of the deals than in the total amount lent. Not only are companies able to sell debt with very low yields, they are dictating the terms. Companies have extended the maturities of their bonds and loans, adding to their riskiness, even as the yields come down. Investors are willing to lend against looser and looser definitions of operating profits, and lend more. Protective covenants have all but disappeared from the loan market, removing what was once regarded as a vital protection for investors. And there is anecdotal evidence of hedge funds not usually present in the market buying in, suggesting less informed investors are getting involved–perhaps drawn by the 24% return on U.S. junk bonds since the oil panic began to recede in February last year.” WSJ
“It’s a really good time to be an issuer,” said Andrew Whittaker, vice chairman of investment bank Jefferies. The flip side is it is not such a good time to be a lender or an owner of bonds and loans. “When you look at the erosion of underwriting standards, you look at the increased leverage that’s coming in to the market, you look at the preponderance of direct loan providers, somebody’s getting more aggressive,” said Scott Evans, chief investment officer of New York City Retirement Systems, America’s fourth-largest pension scheme. “There’s too much capital floating around, and this has never ended well.”
“I think credit, at least some pockets of credit, looks expensive and looks tighter than it used to,” said Bjarne Graven Larsen, chief investment officer of Ontario Teachers’ Pension Plan, Canada’s biggest. “But it diversifies, and spreads [over government bonds] could even tighten further. If nothing happens, you can collect the risk premium.” That risk premium, the extra yield on offer for high-yield bonds above equivalent Treasurys, stands at just 3.8 percentage points, not far above the post-2008 low of 3.4 points reached in the summer of 2014. In the past, it has fallen even lower, reaching 2.5 points just before the 2007 credit crunch and before investors realized the extent of the 1997 Asian crisis. But at these levels, investors need a lot to go right. As Mr. Evans says, “If everything goes right, we will be fine, we will get a very modest return for taking a high degree of risk.” WSJ
In the meanwhile, the yield for the 10-year note TMUBMUSD10Y, -0.45% fell 1.8 basis points to 2.380%, slipping from its eight-week high of 2.405% recorded a day before. Bond prices move inversely to yields; one basis point is one hundredth of a percentage point. The yield for the 2-year note TMUBMUSD02Y, +0.61% edged off 0.4 basis point to 1.343%, while the 30-year bond TMUBMUSD30Y, -0.35% lost 1.1 basis point to post 3.016%.
In short, right now all eyes are on both the stock and bond markets to determine which will end up getting it right. Only time will tell.
by Umar Farooq