INSIGHTS

On June 27, 2012

The Fed, the Spread and the Corporate Debt Conundrum

Taking a look at the myriad of news on a daily basis creates many opportunities to scrutinize perpetuated perceptions for validity. Here are just a few possible different stances on them.

The Fed has been chastised for not announcing more accommodative moves to assist the economy and questioning about the effectiveness of Operation Twist. Many are even questioning why they wouldn’t increase the size of Operation Twist (buying U.S. Treasuries to create a low interest rate market that they hope will stimulate housing and interest rate costs to consumers). However, haven’t the panicked investors already assisted the Federal Reserve? With low rates resulting from the flight to safety, households have increased their holdings of U.S. Treasuries from $256 billion at the end of 2008 to the most recent release from the Federal Reserve ending Q1 2012 of $1.308 trillion. Since the end of 2008, the 10-year has actually declined from 2.21% to a current 1.62%. It has ranged from a high of 3.98% to a low of 1.45%. While we would agree with the synopsis of “don’t fight the Fed,” we would argue a better choice is investing in the impacts from the Fed’s investments versus the actual investments themselves, at this time.

The resulting impact of the yield curve has now found a new audience that finds it of no use in interpreting the potential growth of the economy. Normally, a steep yield curve shows economic growth and or inflationary concerns. With the Fed tethering short-term rates at near zero, and Operation Twist and flight to safety pushing longer-term bond yields down, the yield curve stands at roughly 260 basis points. Taking into account the Fed’s impact, we see the best way to measure the yield curve is between the 30-year yield and 10-year yield. Over the last two decades, the spread has been as wide as 100 basis points three times (1992, 2002 and 2009). What occurred from the peak of this spread to ultimate trough shows what happens to risk assets. The S&P 500 returned an annual return from 1992-2000 of 19.03%, from August 2002 to February 2006 of 11.7% and from November 2009 to the present an annualized return of 9.46%. The average return of the S&P 500 over that entire time averaged 7.35%. Removing the current returns since the period has not played out entirely, one sees an average return nearly twice that of the entire time when the 30-year and 10-year spread is wide (as is the case now). This confirms the Fed’s success in shifting investments toward more risk-prone than risk-averse instruments. It also confirms that not “fighting the Fed” works as long as one invests in the impacts of their actions, not necessarily in the same investments.

With the uncertainty, the flock to the dollar and U.S. Treasuries has seen worldwide corporate bond sales slow. According to Bloomberg reporter Charles Mead, in his article “Diminished Need for Cash Cuts Global Bond Sales” 06/27/2012, “Sales which were up 12% at the end of March, have declined to $1.90 trillion this year from $1.99 trillion in the first six months of 2011….” It appears that many companies, flush with cash have no need for an increase in debt. Consider the two dynamics showing cash and equivalent positions and total debt of the S&P 500. Similar ratios are shown in the Russell 3000.

What we see is an interesting dynamic that has not seen such a balance sheet repair in the last two decades where total debt per share has dropped nearly 40% from its peak while cash has risen 53% on a per share basis. This clearly confirms the other significant discounts to the equity market versus historic benchmarks, but also reveals another potential shift.

If supply of corporate sales is stagnant, balance sheets are showing significant cash levels and an investor that is very hungry for yield, a significant compression in spreads and rally in corporate bond prices may result. With spreads on many issues well beyond their average historic norm, the impact of not fighting the Federal Reserve may well show price strength in the debt as well as equities.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at ~/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com