By John Parry - Analysis
NEW YORK (Reuters) - Corporate bond yields seem high enough to outstrip inflation once the U.S. economy recovers, but huge government debt issuance could ensnare all fixed income markets, including corporate debt.
Until recently, analysts were concerned about the threat of deflation and a potential depression, dismissing an inflation scenario for bonds as tomorrow's problem.
But for bond markets, which anticipate future economic trends, tomorrow may have already arrived.
Investors are starting to bet that the worst economic downturn in decades will soon bottom out, as the rebound of stocks, commodities, and bond yields appears to be signalling.
Inflation hawks worry that a rise in Treasury yields may be followed by yields on other bonds. Inflation, which devours fixed income securities' value over time, is a bete noire for bond investors.
"Right now we are starting an economic recovery with extremely low interest rates," said Howard Simons, strategist with Bianco Research in Chicago. "They are not going to go down from here.
"Nominal rates could rise faster than expected inflation," he said.
The benchmark 10-year U.S. Treasury note yield is now above 3 percent, more than a percentage point above its five-decade low hit in December amid a scramble for safer assets in the financial markets meltdown of 2008.
Some fear a repeat of the early 1980s, when U.S. inflation surged to about 14 percent and the 10-year Treasury yield then peaked at 15.8 percent. An investor buying the benchmark note today at about 3 percent could incur a huge price loss if yields climbed so dramatically.
Analysts warn that the triple threat from massive money printing to fund the U.S. government's financial rescues, the danger of a dollar crisis and concerns that the biggest foreign holders of Treasuries may balk at the low yields on offer could make history repeat itself.
The U.S. government is expected to issue some $2 trillion (1.3 trillion pounds) of Treasuries this fiscal year alone. That prospect has already pushed the benchmark 10-year Treasury note yield up to 3.20 percent for the first time since November, even though since March, the Federal Reserve has been buying government securities to keep borrowing costs down.
"You had a 30-year bear market in bonds from 1950 to 1981 and then you had a bull market through December 2008," said Bryan Taylor, chief economist with Global Financial Data in Los Angeles.
"Interest rates and yields will go up from here," Taylor said. "It could turn out to be another 30-year bear market, depending on how government reacts," he said. If the Federal Reserve doesn't hike interest rates fast enough, inflation could spiral out of control.
Since bond prices and yields move inversely, a big jump in yields would leave bondholders with big price losses.
"Corporates are safer, at least in the initial phases of inflation. They should outperform Treasuries because they are starting out from such a high spread," Simons said.
At first, while inflation was still modest, corporate bond yields would amply compensate investors: a prospect which is currently tempting buyers into the corporate bond market.
According to Merrill Lynch data, the aggregate U.S. investment grade corporate bond yield spread over Treasuries was at 478 basis points on Monday, below the all-time peak of 656 basis points in December, but still historically high.
Yet a major upsurge of inflation will ultimately erode the value of corporate bonds too, analysts say.
"After the initial phases, corporate bonds will get shellacked," said Simons. If inflation reaches early 1980s levels, investment grade corporate bond yields could jump to 16 percent, roughly doubling current levels; a money-losing prospect for investors who buy today, Simons warns.
"On corporates, you would win the spread game," said Jack Malvey, a financial markets consultant in Montclair, New Jersey. But in the next two to three years the U.S. 10-year Treasury yield may jump to 6 percent and corporate bond yields could also rise substantially, Malvey warns.
Yet what happens to inflation expectations and hence bond yields on tentative signs that the worst economic downturn in decades may be starting to bottom is already a worry for some.
"Until now the best asset to own has been Treasuries," which have delivered strong returns throughout the global financial crisis," said Don Coxe, chairman of Coxe Advisors LLC in Chicago, who advises clients of the BMO Financial Group.
The U.S. 10-year yield is more than two percentage points below its June 2007 peak above 5.30 percent just before the global financial crisis erupted.
Yet those holding nominal government bonds now could get their fingers burnt. It's much safer to be holding inflation-protected securities, Coxe argues.
(Reporting by John Parry; Editing by Kenneth Barry)
