From Mark Grant, author of Out Of The Box
Not All Prayers Are Answered Affirmatively
“As long as there are tests; there will be prayer in schools.”
Because I pay attention to these things; I have the sense that there has been a lot of praying recently. Prayers for QE3, prayers for Quantitative Easing mortgage bond buying, “Please SIR;” and for words to the effect in each and every FOMC minutes that “Money will be printed forever and ever Amen.”
“Now I know I'm not normally a praying man, but if you're up there, please save me, Superman!”
Now I hate to do this to you and I feel like the bad boy with the pin about to prick someone’s bubble but these prayers have gone unanswered as you know and are not likely to be answered any day soon unless Europe goes up in pixie dust which, while certainly possible, will be far more serious for the markets and will more than offset the Fed dragging out their printing presses and plugging them in once again.
The Ten Year Treasury Auction
Yesterday’s ten year auction was slightly on this side of strange or perhaps weird and requires some explanation. Somebody, somewhere needed good collateral and in size and was willing to pay almost anything to get it. The average yield of 1.459% was a record for the auction as well as the spread to the “when issued” yield which was also a record. In case you are wondering about the demand it was 3.61 which was the second highest on record with only the April 2010 auction beating it at 3.72. Interestingly enough the Primary Dealers only took down 14% of the auction which was a record low in recent years while the “Direct” bids scooped up a record of 45.4% of the bonds as they submitted $16.9 billion in bids. Further only 51.7% of this Dutch auction came at the high yield while the low yield that got bonds was 1.36%. I think it is a high probability that a lot of the demand was European money which is why everything was askew. With the ECB paying ZERO for short money and the short bonds of Germany, France and the Netherlands in negative territory there is now a vast increase in demand for Treasuries which, while not paying much, at least pay something and you may expect the demand to continue. I am on the record calling for a 1.25% ten year and we may go through that now. The European Central Bank’s move to zero short rates was done in the hopes of encouraging lending but that is not the likely result. The move by the ECB will push money into Treasuries and other “riskless” assets as Grant’s Rules 1-10, “Preservation of Capital,” continue to operate where keeping one’s money continues to be more important than the return on one’s money so that the downward pressure on Treasury yields continues.
Finding Yield in these Markets
Quite some time ago and repeated for a number of times since; I have said that I would stay in Treasuries and buy certain corporate bonds for yield and pare back or remove myself from the equity markets. The bond concept has worked fine while equities lingered but, when questioned about this, I stated in my commentary and in the media that I thought the bond markets were leading the way and equities would catch up which they certainly seem to be doing. Europe is in a recession and the infection is spreading both to America and to Asia and corporate earnings are just now reflecting the results.
Recently I worked with a client to build a new bond portfolio and I stuck to my guns and waded into the financial credits to find yield. Here I have been quite specific about what should be bought; American banks, British banks and various other Dollar financial names when they can be found. Depending upon your risk appetite you can get yields that are more than 6.00% and in some cases 8.00% and still sleep at night. Many of the Hybrids/Trups have been tendered for and the ones remaining present good value in my opinion as cheaper funding is obviously available these days and the use of these securities for capital is no longer allowed. I favor credits like Bank of America, Citi, JPM, Barclays, RBS, Lloyds et al. In my mind the banks of America and Britain are miles away from the European banks where I see such a large amount of risk that I cannot suggest them to anyone.
As a matter of the data to date the U.S. banking sector has outperformed every other sector in bonds this year according to the Bank of America/Merrill Lynch Index. The return for dollar denominated banks has been 8.1% versus 5.4% for non-financials. Bank debt has actually been declining this year for the first time since 1991 while new capital has been raised to comply with the Basel III regulations. In fact, corporate bank bonds have returned almost twice as much as equities this year while remaining much higher up in the capital structure which may prove to be quite useful as the situation in Europe continues to deteriorate. The American and British banks have more liquidity and less leverage than at any time in a number of years and for those of you that continue to be light in this sector I think you should re-look at your asset allocation models.
The play continues to be out of Europe, out of Euro denominated bonds, out of European sovereigns, out of European banks and into Treasuries and American and British banks as the compression will continue in my view.