Monday, September 29, 2008

Corporate Bonds: When Safe Asset Classes Become Risky


We hear about "credit crisis" and "risk aversion", but I thought I would make those issues much more concrete for readers. This is not some volatile stock or sector, and it's not a bank. This is a chart of LQD, the iShares Investment Grade Corporate Bond Fund. Note that it's not a junk bond ETF; rather, its holdings are considered investment grade. With the current credit crunch, however, there are increasing fears that companies will not be able to sustain interest payments on bonds. This has created a dramatic selloff, in which LQD has lost 20% (!) of its value in the last three weeks. When you consider the individual retirement accounts, pension funds, and other prudent investment accounts tied to what has been a relatively safe asset class, you can appreciate the turmoil that is spreading from Washington and Wall St. to individual households.

And junk bonds? One knowledgeable source is raising the specter of double-digit defaults, given the high leverage of the issuers. The i-Shares High Yield Corporate Bond Fund (HYG) is down over 20% since May, a stunning drop, but lately no worse than the performance of LQD. It appears that investors are running from corporates altogether, dumping the good with the bad.
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8 comments:

Firebird said...

Dr. Steenbarger,

Frankly, after today's moves in virtually everything, all I can manage to say is...

Holy cow!

Best trading,

Jorge

PS: if it is not too much asking, could you please post an entry (or a link to an older post) on how to overcome regret at missing huge opportunities.

PS2: and sorry if somebody is offended that I'm thinking of opportunity in these times, I am well aware of the effects on the overall economy of this crisis and that virtually no one is going to escape it.

Firebird said...

Dr. Steenbarger,

Two observations regarding this market.

1) If you think about it, the market is only a few points lower from where it was on the 18th, before the rumor of government intervention spread. Now we're back to basically the same point (S&P wise), only more violently. In my view this speaks lots about government intervention, but I may be wrong (and the short ban is set to expire on Thursday, regardless of whether they let it expire or not that should be another source of disruption).

2) Although bonds recovered ground as stocks were falling, the 30 years bonds are still 3 whole figures below their highs on the 18th. Is this a tradable divergence? Is it a reflection of perceived broad weakness for US-denominated bonds? If so, why isn't the dollar plummeting (not again the euro, which considering the bank bankruptcies makes sense, but how can it be up against the yen, for instance?).

Best trading,

Jorge

Bill aka NO DooDahs! said...

LQD got hammered worse than HYG because so many of the large financial companies were highly-rated; LEH, AIG, etc. So it's not really a flight from high-grade corporates so much as it's a function of the specific bonds held by LQD.

procol said...

I spend quite a bit of time watching preferreds trade.

I can tell you that they have traded like toilet paper for months now.

Closed end funds have been decimated in many categories.

Not everyone waits for a 777 down day to sell. The smart money is long gone.

John said...

Brilliant chart Brett.
John Rutledge
www.rutledgeblog.com

Bill aka NO DooDahs! said...

@ procol: Watching preferreds trade must be like watching paint dry, most of the time.

Qualitative differences:

(1) good-standing preferreds discounted vs Ts
(2) junk discounted vs good-standing preferreds
(3) bad-standing preferreds that shouldn't have been preferreds, discounted vs junk
(4) closed-end ETFs that hold items (3) discounted vs (1) and (3)

That's my point, and it's specific to the LQD vs HYG dynamic that I mentioned.

Feel free to ping us all when the "smart money" comes back into the market. We'll be waiting.

Bill aka NO DooDahs! said...

Typo should be "(4) closed-end ETFs that hold items (3) discounted vs (1) and (2)" my apologies.

procol said...

I assure you, the preferred market has been every bit as wild as the common , and even more so for quite some time now.