Thirst For Yield Quenchable With BB-Rated Paper
Tight spreads, what we now have, can last for years. Spreads contract when GDP accelerates because nobody is concerned with declining fixed-charges coverage. BB corporates rose over 14% in 2014, the best return for all U.S. asset categories excepting the Nasdaq 100 Index.
I sense we’re facing a comparable situation today. Don’t despair. Economists, even traders rarely catch inflection points. I’ve learned to do all the work but then follow my gut feel. This tells me that risk aversion now is overdone. Buying quality bond paper won’t do.
Same goes for stocks. Five years ago, Exxon Mobil stock traded at par. Then, retracement began in a declining head and shoulders chart, a most bearish picture. Of late, Exxon probably touched bottom at $65. Present dividend yield, 4.4%, is double the Big Board’s median, but it doesn’t compete with AT&T at 6.5% or even Schlumberger’s 5%.
The thirst for yield is quenchable but not with a Coca-Cola or PepsiCo. Turn down money market funds at 2% and say no to brokerage house offers of “guaranteed” funds, some even below 2%. Ten-year Treasuries yield 2.5%.
The Street just got busy marking down yield projections on 10-year Treasuries to 3% by year-end, not 3.25%. Fewer bumps coming from the FRB— maybe, none. Corporate debentures key off yield expectations on 10-year Treasuries. When you refer to historical spreads in a benign setting, bedrock findings resonate.
First, focus on the real yield for 30-year Treasuries. This determines not only attractiveness of the stock market, but whether the bond market is playable. When such paper sticks below a real yield of 4%, the market multiplier does range as high as 18 times earnings, sometimes 20, like this past September. But, as the business cycle ebbs and flows, multiples of 20 never last for long. Witness the past four months’ correction.
For bonds at a real yield of 5% much depends upon perception of the players. When inflationary numbers percolate the market turns unattractive. In 1982, Paul Volcker tightened interest rates in an inflationary environment of 7% to 8%. Yields on all maturities of bonds zipped to 15%. This was a one-time painful event. The S&P 500 Index reverted to book value and yielded 5%, just like early 2009.
In a more normalized environment, what we have today, at least pertaining to earnings, interest rates and inflation, The Street sees the market at 3,000, nearly 20% above where we tick now. This of course is pie-in-the-sky optimism, but if you believed it, capital allocation to bonds would be zero. Bonds wouldn’t earn more than their coupon, somewhere between 3% and 5%, probably zero as inflationary expectations percolate.
Today, nobody’s more than tentative on whether GDP accelerates from a 2% pace. The analysis changes into a spread-game situation. Now, most players are afraid of high-yield paper, anything below investment grade. But, that’s where yields of 6% dwell. The fear of declining fixed-charges coverage has moved to the foreground, unreasonably.
If you feel as I do that inflation is contained with no recession in sight, below investment-grade bond paper beckons. I’ve more capital in BB debentures than I do in equities. The spread between 10-year Treasuries and BB paper with durations of at least five years approximates 300 basis points. At least historically this spread is okay for investment. Just be right about trend and direction.
In the sixties, I remember visiting Sidney Homer, a senior Salomon Brothers partner whose book on the history of interest rates is a must read. It covers 5,000 years. What happened when the wheat crop failed in Egypt in biblical times reminds me of the bread riots in Paris, 1789.
Sidney’s office perimeter was decked with charts showing monthly changes in spreads for Treasuries and corporates. Any violent swing called for a trading decision. Not that Solly’s traders religiously listened to Sidney or to their economists like Henry Kaufman, whose annual study on the supply and demand for funds was a must-read for all of us.
Currently, I have no use for investment-grade corporates where the yield spread to 30-year Treasuries is a skimpy 100 basis points at best. Consider, even BAA bond yields minus 10-year Treasury paper normally runs at 250 basis points, but today is closer to 100. Polite investors condemn themselves to yield-starvation bonds.
Unless you can go below investment-grade paper, best stick to the money market or two-year Treasuries with yields of 2.5%. No reason to buy corporate-commercial paper. While yields on non-investment-grade leveraged commercial loans are tied to money market rates, loan quality is indecipherable so I don’t play therein.
I play mainly in BB corporates with average duration of five years. Speculative exceptions like Chesapeake’s bonds got my money, too. If you believe banks avoid serious trouble in the next couple of years, their preferred stock selling at little premium over call prices offer yields up to 6%, but little or no appreciation possibilities because of call provisions in their indentures.
Enormous swings in sentiment for even BAA-rated bonds show how crazily corporates do trade during a business cycle when real GDP is shuffling along between 3% and 4%. These bonds can trade as low as a 150 basis point premium to 10-year Treasuries. When the bond players sniff recession in the air, premiums widen to as much as 350 basis points.
During the financial market meltdown of 2008-2009, yield premiums spiked to 650 basis points. Hysteria is built into the corporate debenture market. Even in the tech-bubble-induced recession of 2001, yield premiums on BAA corporates zipped up from 150 to 350 basis points and then declined steadily for the next five years. All this happened while 10-year Treasury yields ticked at 2.2% with the Fed Funds rate a minimal 25 basis points.
Typical Fed Funds historically average closer to 4%. Now, nobody sees much tightening coming. If it does, professional panics in the bond crowd get compressed into a couple of months. When I looked at a 30-year chart on Fed Funds, I was surprised to see a trendline closer to 6% when the economy was in a growthy condition. In a weakening state, junk bond yields can range easily between 500 and 700 basis points above five-year Treasuries.
Not so long ago, Chesapeake Energy’s bonds traded at $60, now $97, while its common stock advanced 40% in the past couple of weeks (oil futures spiked). To be a player you gotta crave volatility in junk and go against the grain of prevailing junk market sentiment. With more deflation than inflation in the air, I’m a player. The Fed is finally on hold, but nobody’s pushing BB or below rated paper yet.
Finally, you’ll never like quotes dealers give you on high-yield paper, going in or coming out. I tell them I don’t mind being taken for quarters, even halves. But if they stretch for full points, I’ll barge onto their trading floor and snip off their manhood. Ya!
Sosnoff and / or his managed accounts own: AT&T and Chesapeake Energy bonds.