Think Corporates Are A Safe Haven? Think Again

Yields on some corporate bonds are trading below their U.S. Treasury counterparts suggesting dwindling credit risk in the bond market according to the Wall Street Journal. In the article “The Federal Reserve Does Not Care If Treasury Rates are Higher ”, the Federal Reserve’s latest Quantitative Easing program is a huge driver of demand. The Fed’s purchases of Mortgage Backed Securities, after all is said and done, will undoubtedly overwhelm the amount of new issuance for most taxable bonds which may result in a net supply of zero or perhaps even negative. A money market bond investor who needs to buy but is having a hard time finding bonds will pay up so he can stay fully invested.

In addition, the European Debt Crisis and the potential of contagion to the financial sector may drive away money market players from investing in European banks' commercial paper programs. This may lead investors to seek their returns elsewhere and drive up the price in limited supply securities like the aforementioned short dated corporate bonds.

Whatever the case may be, what we are seeing should look familiar since long time bond investors will know that we have traveled down this path before where the incremental yield between safer and riskier bonds compresses.

Prior to the Long Term Capital Market debacle back in the late 1990s, an investor could own Merrill Lynch 5-Year bonds with a ‘AA’ rating at 60 basis points over Treasuries while pick up an additional, miniscule 5 basis points to go to the bottom end of the investment grade scale by buying Lehman Brothers 5-Year bonds.

Back in 2006, bond investors could buy so called ‘AAA’ subprime bonds for 25 to 30 basis points over LIBOR. Credit spreads were tight simply because investors were desperate for return and needed bonds. Carry was king, and the objective of remaining fully invested over risk control determined their actions. As we all know from the financial crisis, the spread on these instruments did not stay at that level for very long.

Common sense and experience tells me to not read into short dated corporates trading below U.S. Treasuries. Corporate issuers are not safer than U.S. Treasuries and the market is not about to embark on a “new era.” Also, this isn’t a sign that the default probability of U.S. Treasuries is increasing because of the country’s budget problems. In fact, I would look to a falling dollar if that is indeed the case.

Furthermore, if I were an owner of said corporate bonds, I would sell JNJ and XOM bonds and buy U.S. Treasuries. Yields may trade below Treasuries and this may continue going forward given the Fed’s influence on demand. However, the upside should be limited while it is just a matter of time before corporate spreads widen.

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As illustrated by the two examples, it has happened before and will happen again and is far from anything new. The fact that history repeats itself in some form or another where corporate spreads widen is probably the safest of bet of them all.

Disclaimer: The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.

Written By: Bondsquawk