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High Yield Safer Than Treasuries?

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This week we had a jobs report that rocked the bond market – well, not all the bond market, but the treasury market.

The unemployment rate dropped to 10% and treasuries dropped like a rock. That drop just continues the downward pattern that started in October (see the red/black line on the chart above).

However, the junk bond market responded by rallying. This points out one of the odd things about investing in bonds – good news for the economy is bad news for “safe” treasury bonds, but good news for economically sensitive junk bonds and convertible bonds.

The reason for this is that an improving economy is good for the issuers of corporate debt but bad for treasury bonds as the market anticipates that the Fed will have to start raising interest rates to combat inflation.

Bond prices rise/fall inversely to moves in interest rates (whether actual moves or anticipated moves – it doesn’t matter). However, in the early stages of an economic recovery, junk bonds and investment grade corporate debt tend to increase in value as they trade more on the prospects for the issuing corporations than on interest rates.

This, however, changes once the recovery gets to a plateau level and contracts.

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On this chart, you see a long term view of the 30-year treasury versus a typical junk bond fund. I want you to look at the big dip in in the price of treasuries in 1993/94. That was a very painful time to own treasuries as they crashed over 30%, but you can see that high yield performed amazingly well as the economy improved throughout the 90’s.

Going forward? Much depends upon your view of the economy over the next couple of years. If we see a steadily improving economy with slowly improving fundamentals and falling unemployment, you could easily see a repeat of this pattern from 1993/94.

However, if you are in the double dip recession camp, then you could easily see treasuries rally and high yield fall, much like the pattern from 2000 to 2003.

Right now, the Fed is giving us a Christmas gift of massive liquidity but treasury bond investors are just not happy. They are taking this gift and seeing a problem. The gradually improving economy and recent weakness in the treasury market are a pattern we have seen before, so if you own treasuries, be aware of how this can all play out.

Mark