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Mid-Week Liquidity Update: A Discussion of High Yields

(June 7, 2007)

Dear Subscribers and Readers,

As I am finishing up this commentary, the 10-year yield has finally surpassed the 5% level.  While we can argue about what is causing this all day (the mainstream media is blaming a potential new round of global central bank rate hikes for this latest rise) – the fact remains – borrowing costs are rising and liquidity is continuing to decline.  The big pillar of support for liquidity - the Yen carry trade – is also in danger of ending, as the Bank of Japan is now expected to raise borrowing costs again as early as August.  Obviously, this will depend on upcoming economic data, but economists and analysts alike are now expecting final 1Q annualized GDP (to be released on June 11th) to be revised 2.6% to 3.6%.  If that is the case, then the 1Q GDP growth in Japan will be significantly higher than both growth in the US and in the Euro Zone.  Despite a continued threat of deflation and the lack of growth in household consumption spending, there will be no more reason to leave overnight rates at an ultra-low level of 0.5%.

Bill Rempel of usually writes a guest commentary for us on the first Thursday of each month – but Bill was on a business trip earlier this week and did not have time to finish up his commentary.  For those who have been looking forward to his exclusive views on the market or on individual stocks – don't worry, he will be back next week.

There is a couple of things I want to mention before continuing on with this mid-week commentary. Yesterday morning, Morgan Stanley issued a “full house sell signal” on UK and European equities.  This sell signal is based on the following three indicators:

a. The median P/E of the MSCI Index of 600 European and British equities, relative to bond yields

b. An indicator measuring the outlook of growth vs. inflation (Morgan Stanley is very vague about this)

c. An indicator measuring the risk appetite of investors.  Morgan Stanley claims that investors are now “taking far too much comfort” in the current global liquidity level – and that there are now too many fools with too much money to spare.

Since 1980, there have only been five such signals from Morgan Stanley's model.  Moreover, the last signal occurred in early 2000, right at the peak of the last bull market.  From this author's vantage point, I believe I will now have to agree with Morgan Stanley, given the decline in corporate profit growth, recently rising bond yields, and the fact that many formerly bearish commentators have now “capitulated” on the bull side (I am not going to mention any names here, but many of these commentators have been bearish for awhile now and have only just recently turned bullish).  Finally – if one was looking for the “signature event” of too many fools with too much money, then look no further than this: The Zimbabwe Fund has recently been inaugurated and approximately £100 million has been raised for the fund.  Moreover, investors were literally falling over themselves to get into the fund, as the manager of the fund had to ultimately turn away investors, citing the difficulty in deploying so much capital.  In the next global recession, it will be difficult to get folks to invest in GE, WMT, or MCD.  Most likely, ventures such as this will ultimately return little more than pennies on the dollar for their investors.

I now want to discuss the topic of high-yield bonds.  A couple of days, I had the privilege of attending a luncheon hosted by Marty Fridson, long considered as the authority on high yield bonds.  After his discussion on high yield bonds, there was no doubt on what his current views are: That high yields are overvalued right now and that we be nearing the end of the benign cycle, although like everything else in the markets, timing is always uncertain.  Moreover, the corporate bond market today – as broken down by rating classes – is very similar to the mix at the beginning of 2000.  Based on this mix – if we are to have a “soft landing” scenario at some point over the next couple of years, then there is a good chance that we will experience similar default and default loss rates similar to the 2001 to 2002 period in the corporate bond market.  Mr. Fridson emphasized, however, that the recession of six years ago was one of the mildest on record.  Should we experience a “hard landing” similar to the 1990 to 1991 recession – then most likely, we will experience corporate default and default loss rates not seen since 1933.

I will now show you a couple of charts:

Monthly Chart of Baa Versus Treasuries Spread (January 1987 to May 2007) - The spread between Baa and Treasuries hit a level of 1.17% at the end of May 2007, close to the 1.12% cycle low made February 2006 and January 2007. For comparison purposes, the record low of this spread was 0.89% recorded on July 1997, right at the beginning of the 1997 Asian Crisis.

The above chart shows the monthly spread of the yield of the Lehman Baa Index vs. the Lehman Treasuries Index.  While bonds that are categorized as “Baa” are still regarded as investment grade bonds, they are definitely at the lowest end of the totem poll when it comes seniority or claims on residual assets in the event of a corporate bankruptcy.  As defined by Street Authority, Baa bonds are: “Bonds of medium grade quality. Security currently appears sufficient, but may be unreliable over the long term.”

While Baa bonds are definitely not an indication of how speculative the high yield market is, it definitely does give you a good indicator of how much risk that corporate bond investors are currently taking.  As indicated on the above chart, the spread between the yield of the Lehman Baa and the Lehman Treasuries index hit a level of 1.17% at the end of May, which is close to the current cycle lows of 1.12% made on February 2006 and January 2007.  Note that for the former, this was a mere two and a half months before the May 10, 2006 top, and for the latter, just a month before the stock market swoon from February 27 to March 14 of this year.  One thing is for sure, we are now closer to a top than a bottom in the U.S. and global stock markets.

Since this commentary is on high yields, however, I now want to show you another chart.  In many ways, the following chart – showing the monthly spread of the yield of the Lehman CCC Index vs. the Lehman Treasuries Index – is much more instructive since this spread really captures how speculative the corporate bond markets right now.  Without further ado:

Monthly Chart of CCC versus Treasuries Spread (January 1987 to May 2007) - The spread between CCC bonds and Treasuries hit a record low level of 4.01% at the end of May 2007, shattering the previous low of 4.38% made on January 2007. For comparison purposes, the CCC vs. Treasury spread hit lows of 4.69% in August 1987 (right at the peak of the 1987 bull market), 5.24% in February 1994 (the year when we experienced huge corrections in both the stock and the bond markets, culminating in the Orange County bankruptcy), and 5.51% in March 1998 (right before the market peaked and then crashed in August to October 1998).

Note that the spread between the Lehman CCC Index vs. the Lehman Treasuries Index has just touched an all-time low of 4.01% at the end of May 2007.  For those who want a refresher, a bond with a CCC rating has the following quality: “Bonds of poor quality. Issuers may be in default or are at risk of being in default.”

For comparison purposes, this spread of the most speculative class in the corporate bond market vs. U.S. Treasuries is now at its most speculative ever.  While the spread has never gotten this low before, we did, however, witness similar lows in August 1987, February 1994, and March 1998.  And – as the above chart shows – we all know what happened afterwards (do the 1987 crash, the 1994 rout of Wall Street traders and the Orange County Bankruptcy, 1998 Brazilian, Russian, and LTCM crises ring some bells?).  For those saying that “we still have too many bears” for this to mark a significant top, I suggest you look again.  While this author does not believe the cyclical bull market has ended yet, I do, however, believe that will have a very tough summer and Fall (no pun intended) over the next three to six months.  Readers please stay tuned.

Signing off,

Henry To, CFA

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