I have been warning everyone about corporate bonds specifically because of rising default risk and rollover risk for quite some time. And indeed Corporate bonds are getting crushed. Here is a chart of Moody’s Seasoned Baa Corporate Bond Yield.

Baa Corporate Bond Yields

click on chart for sharper image

Moody’s tries to include bonds with remaining maturities as close as possible to 30 years. Moody’s drops bonds if the remaining life falls below 20 years, if the bond is susceptible to redemption, or if the rating changes.

Chart and text courtesy of St. Louis Fed and Moody’s.

Armageddon Prices Fail to Lure Buyers

Bloomberg is reporting ‘Armageddon’ Prices Fail to Lure Buyers Amid Selling

Credit markets have fallen so far that they are providing a “once in a lifetime opportunity,” and investors are still selling.

Prices of loans rated below investment grade declined to a record low 66.1 cents on the dollar, virtually guaranteeing investors get their money back, based on historical recovery rates, according to data compiled by Standard & Poor’s. Yields on corporate bonds show investors expect 5.6 percent of the market to go bust, the highest default rate since the Great Depression, according to Christopher Garman, chief executive officer of debt research firm Garman Research LLC in Orinda, California.

“There has been widespread liquidation of assets that has nothing to do with fundamentals,” said Scott D’Orsi, a partner at Boston-based Feingold O’Keeffe Capital, a hedge fund which has $1.3 billion in assets. “Investors in bank debt are being presented with a vast number of extraordinary opportunities; opportunities that I would characterize as once in a lifetime.”

About 90 percent of the market trades like high-yield, high- risk, or junk, debt, Garman said in an Oct. 3 report to clients. Prices imply a 5.6 percent default rate, the most since the record 8.4 percent in 1933, he said. Junk bonds are rated below BBB- by S&P; and Baa3 at Moody’s Investors Service.

“It’s quite possible that we had priced in Armageddon,” said Robert Gahagan, head of taxable fixed-income in Mountain View, California at American Century Investment Management, which oversees $23 billion in fixed-income assets.

Once In A Lifetime Opportunity

There was indeed a once in a lifetime opportunity, with the key word being was. A quick look at the above Baa chart shows there was a once in a lifetime opportunity to sell when risk premiums for junk shrunk to insanely low levels. That opportunity occurred between 2005 and 2007. Everyone was foolishly chasing yield then, at ever ridiculous risk spreads in spite of rapidly deteriorating fundamentals in housing, commercial real estate, and the global economy.

In terms of buying corporate bonds, the Baa chart above is back where it was in 2001, essentially where it was 7 years ago. We will take a look at fundamentals in just a bit but first let’s consider performance along the yield curve.

Corporate Bond Performance Along the Yield Curve

Brett Steenbarger at Trader Feed has an interesting post Corporate Bonds: Year-to-Date Price Performance Along the Yield Curve that is well worth a look.

Corporate Bond Performance

click on chart for sharper image

Above we see year-to-date price performance for four corporate bond funds in the Vanguard family: short-term investment grade (VFSTX); intermediate-term investment grade (VFICX); long-term investment grade (VWESX); and high yield (VWEHX).

What we see is that, as the yield curve has steepened, longer-term bonds have dramatically underperformed shorter-term ones.

Even more dramatic is the way that high-yield bonds have underperformed investment grade offerings. The bonds in VWEHX are roughly the same in maturity as those in VFICX, yet it has been almost twice as weak in price performance. Safety has ruled the roost for 2008; this remains an excellent market sentiment indicator.

A Lesson In Fundamentals

Scott D’Orsi, at Feingold O’Keeffe Capital stated “There has been widespread liquidation of assets that has nothing to do with fundamentals.” I disagree. I believe there is a very valid fundamental reason for safety to be ruling the roost. Here is how I see it.

The Fundamentals

  • This was the biggest credit bubble in the history of mankind and the bust is going to be the biggest since the great depression.
  • Unemployment is rapidly rising and is nowhere near peak. I am looking for 7.5%-8.0% unemployment in 2009 and continuing higher in 2010.
  • There is a New Age of Consumer Frugality that will affect consumers’ willingness to make purchases
  • Frugality is hitting state budgets as 22 States Face Tax Shortfalls
  • It will be impossible for corporations to roll over debt at attractive prices.

Prices imply a 5.6 percent default rate, the most since the record 8.4 percent in 1933 but here is the question on my mind: Is 5.6% that so outrageous in the wake of the biggest credit bust in history?

Whether or not corporate bonds are a buy now is debatable. The highest quality corporates might be. Yet lesser quality, especially junk, might be another story altogether. And it is a considerable stretch of the imagination to state or imply anything remotely close to “This is a once in a lifetime opportunity”.

That once in a lifetime opportunity was to sell, and that opportunity is long gone.

Mike “Mish” Shedlock
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