SOC Recommends:

Stay Away from All Bonds…Except Treasuries!
There’s no doubt in my mind that ALL bonds continue to offer the poorest values in history.
And if “past is prologue,” (as my colleague Bob Bauman said yesterday) the next financial crisis will slaughter bond investors. Risk premiums continue to point to a major disaster ahead. Bonds, especially the non-Treasury market, which includes corporate bonds, high-yield (junk bonds), mortgage-backed and emerging market debt all trade at, or near, their lowest premiums in history versus Treasury bonds.
This has been the case for the last 18 months or so for most high-risk instruments where investors have lunged for capital gains, not yield. And that’s exactly the problem with credit risk today. Investors aren’t chasing yield. Instead, they’re relying on capital growth as coupon yields continue to shrink to historical lows. Worse, some of these investments are actually dizzy speculations backed by leveraged capital in the credit markets. I don’t have to tell you what can go wrong when credit cycles draw to an end.
So just how expensive are high-risk bonds right now? Emerging market bond spreads now trade at just 1.58% or 158 basis points above Treasury bonds. That’s an amazing statistic, considering countries like Turkey and Colombia used to pay almost 10% more just five years ago.
Emerging markets, of course, have been a major recipient of the commodity bull market this decade. These red hot markets have garnered record capital inflows, and booming budget and trade surpluses since 2002. Investors want a big piece of this action and are willing to throw more money at these risky markets like there’s no tomorrow. But they’re not compensating for yield risk at these nosebleed levels.
What about junk bonds? The average yield on junk bonds now stands at 2.75% above benchmark 10-year Treasury bonds. That’s very close to an historic low. It’s pretty low compared to their historical average spread of 4.5% above T-bonds.
The last time risky bonds traded at such low premiums above Treasury debt was back in 1997 – just before the massive near-collapse of hedge fund Long Term Capital Management.
Prior to that seminal event, 1993 marked the next low point following a flood of money created by the Greenspan Fed from 1991 to 1994. By March 1994, the bottom started to fall out from under the high-yield and emerging market bond sectors as interest rates climbed. And before that, 1988 marked another low point ahead of Fed tightening. Then the bond market got slaughtered in 1989 as junk bonds got mauled.
Of course, history always repeats itself. But don’t tell that to Wall Street or London’s finest in the City. The only place to park some money in the bond market lies in longer term Treasury bonds. This segment of the yield curve has been smashed hard this month as the market comes to grips with a suddenly booming economy this quarter after skirting with recession in Q1.
I highly doubt bond yields have much higher to go. I also think the Fed will not tighten interest rates during an election year in 2008. High quality bonds have probably seen the worst of the selling, but that’s definitely not the case with high-yield and emerging market debt.
Whatever you do, avoid non-Treasury debt like the plague!