Market Update – August 14, 2012

I received links to several videos in response to my comments about rhythmic gymnastics.  But, I thought that this was a great one…it’s Will Ferrell’s interpretation of rhythmic gymnastics.  The reader who sent this received a free subscription for the year…

I was traveling today (Monday), so I was quickly trying to find some articles that I found interesting.  I realized that all of the articles I pulled involved the bond market.  Here’s a quick summary of some of the articles that I read (realize that this is not intended to be a treatise covering all issues):

Everyone Loves Bonds

Companies sold $75 billion of investment grade corporate bonds last month.  This was the busiest July ever.

Corporate bonds sold last month paid an average interest rate of 3.2%.  (Over the past thirty years, these bonds averaged 7.2%.)

Investment grade bond mutual funds and ETFs in the U.S. took in $69 billion this year (through July).  By comparison, there have been inflows of $2.1 billion into Treasury funds.

Skeptics Argue

Huge demand for these bonds has pushed yields down too far to compensate investors for risk.

Even companies that don’t need the money are borrowing…because they think money is too cheap.

Many investors are buying bonds because they are simply trying to avoid risk and are scared of stocks.

Investment grade corporate debt is the beneficiary of the pursuit of yield – as Treasuries and German bunds have incredibly low yields.

Corporates yields are simply Treasury yields plus a risk premium.  Yields on Treasuries (the first half of the equation) are too low because U.S. debt is simply the best of the worst.  People are just running from Greece, Spain and Italy.

Rates don’t have much room to go lower.  So, while these bonds may have very low credit risk, investors face significant interest rate risk.  (If interest rates increase, prices decrease.)

There are possible downgrades in the near future if Congress doesn’t handle the “fiscal cliff” (the tax increases and spending cuts scheduled for next year).

Bulls Argue…

The Fed and ECB have given guidance that rates will not increase any time soon.

While rates are low, spreads (vs. Treasuries) are close to the ten-year average of 1.8%.  (Some believe that the spreads could narrow.)

Growth will remain low and inflation expectations will not increase.

Even if there is a downgrade, that doesn’t mean yields will rise.  After U.S. debt was downgraded last year, yields have dropped significantly.

Some of the Effects…

Retirees who have done the right thing (saving for retirement) are receiving tiny yields.

Pension plans are not going to hit their return goals.  Approximately 44 million Americans have a pension and 1.5 million are in plans that have already failed.

Banks are profiting by borrowing for almost nothing and investing in Treasuries.

Insurers make money from their underwriting business (writing policies) and investing the proceeds (float).  Low interest rates are driving investment income lower.  (Life insurers have 40% of their capital invested in corporate and foreign bonds.)  As a result, insurers may need to raise premiums (of course, this is a competitive environment and it is not certain that they can do this). It is also possible that insurers may shift some capital into riskier assets (as long as this doesn’t violate regulatory requirements).

Investors can use cheap debt to buy cheap assets (such as residential real estate).

Governments are receiving false signals about their indebtedness.  As a result of low yields, there’s no urgency to fix the problems.

Have a great week.

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