The sharp rise in Treasury bond yields at the same time as corporate
bond yields have plunged reflects declining risk spreads, even as a
surge in inflation is not a serious concern. Moreover, corporate bond
yields have fallen sharply enough that businesses are aggressively
locking in financing at very low yields. And such rates are now low
enough that bonds are no longer particularly attractive relative to
stocks.
The rise in yields on Treasuries is a very favorable
development. Yields on 10-year Treasuries would have remained near
their 2% low only if investors remained more focused on the safety of
their capital than on the return on their capital. So, those
unsustainable low yields are gone and that’s clear evidence of
substantial improvement in financial market conditions. This is the
reason why the Fed felt no need to increase its buying program of
Treasuries to push those rates back down.
Significantly,
while Treasury yields increased, corporate bond yields fell. That also
signals that investors are more comfortable taking on some risk and
credit conditions are normalizing. Even so, the credit crisis was so
traumatic for corporate financial officers that they are issuing new
bonds and renegotiating credit lines at a rapid clip, even when
outstanding bond issues or credit lines do not mature in the near
term. They just don’t want to take any chances with their
companies. Many have agreed to pay a percentage point or two more to
extend the maturity of their bank lines by a few years. This is very
good for bank profitability, but it also spares CFOs of their worst
nightmare that they may have a bond mature in a dysfunctional credit
market. So, they are financing aggressively while they can.
Bond
yields have fallen sharply, more than seems warranted by a comparison
to stocks. An outstanding article by Michael Santoli in the latest
Barron’s demonstrates that the yield on the common shares of several
major companies exceeds the yield on their bonds. As Santoli correctly
points out, either the bond yields are too low or the stock prices are
too low. Some reaction is likely from both sides, with the eventual
adjustment pushing up both bond yields and stock prices. Indeed, it is
becoming harder to find reasonable bond yields (relative to inflation)
without accepting increased default risk in the junk bond arena. By
inference then, stocks are the better value by far. The path may not be
smooth, but stocks should end the year higher, as incoming economic
data supports the turnaround thesis for the economy.
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