Bonds Sneeze, but Is It Contagious?

By MICHAEL SANTOLI

THE SUMMER HEAT NOTWITHSTANDING, Wall Street is now thick with folks shivering over the collapse of Treasury-bond yields, reading it as an augur of a coming deflationary ice age.

The question, "What is the bond market telling us?" is being asked with growing urgency, mostly by folks who have settled on the answer that the bond market is conveying a message that economic- growth expectations are in peril and that the stock market—which even after last week's dip is in the upper end of its summer range—is ignoring it at grave risk.

The 10-year Treasury yield sliding to a 16-month low of 2.68% shouldn't be ignored or explained away. It's for good reason the stock market was dubbed "the bond market's idiot kid brother." Clearly, at minimum, the 10-year yield at these levels reflects the general reduction in U.S. growth assumptions, both about last quarter and the second half of the year. Yet there is probably more going on here than bonds reliably pricing in another economic contraction that would upend stocks. There's even a chance that neither stocks nor bonds have the outlook wrong. The argument between the two asset classes might instead be a subdued and agreeable discussion.

At the most basic level, both markets seem to have internalized the idea that the Federal Reserve's zero-rate policy is the law of the land for the investable future, and policy makers stand ready to throw money at the economy's problems, be they evident or hypothetical. With overnight lending rates at zero and the two-year note yield barely above half a percent in yield, the incentives for banks and other leveraged investors to simply coast along the yield curve remain strong, even at 2.68% on the 10-year.

There have also been hints that some of the buying pressure on 10-year Treasuries looks forced or mechanical, related to hedging by mortgage-bond investors. One thing is sure: The rally in longer-term Treasury paper hasn't been supported by the largest U.S. bond investor. Pacific Investment Management, which Bloomberg recently reported is taking in $1 billion a week from bond-craving investors, reduced U.S. government-related holdings in its flagship Total Return fund in July from 63% to a still-high 54%.

A more salient rejoinder to the admonition to heed the bond market is, "Which bond market, exactly?"

Because in contrast to the purported economic malaise and acute risk aversion being foretold by teensy Treasury yields, the corporate bond market hasn't flinched at all.

The iShares iBoxx Investment Grade Debt exchange-traded fund (ticker: LQD) traded at nearly a five-year high last week. The iShares iBoxx High Yield Corporate Bond ETF (HYG) has held steady in the last three months, as the 10-year Treasury yield sank more than 20%. If economic and corporate fortunes were due to erode quickly, corporate debt would presumably be sniffing this out as well.

For sure, corporate debt is supported by a couple of strong tailwinds. Very slow but positive economic growth is something near a nirvana state for credit, as strategists at Morgan Stanley noted. Companies can handily service their debt without necessarily growing rapidly, and a sluggish recovery forestalls inflationary fears that can poison returns.

And, of course, the public is bingeing on bonds, and has been for years. In the first half of 2010, investors sent $136 billion in net new money into bond mutual funds, taking the total net inflow since the start of 2009 above $500 billion.

Corporate America has been availing itself of the public's willingness to lend, as the widely noted International Business Machines (IBM) sale of three-year notes at a 1% rate attests. The percentage of new corporate-capital issuance in the form of equity is near a 20-year low. History suggests that what companies are most eager to sell isn't the best buy, and vice versa.

The risk isn't necessarily that there's a bond "bubble," as is commonly heard (especially from folks who sell stocks). A bubble requires that the public be whipped up into a state of enthusiasm over some grandiose "story" about a certain asset class. That isn't happening, unless one considers the sober demographic argument in favor of income instruments.

No, one take-away is that bond investors better be happy with the coupon, because not much absolute appreciation is likely from current levels. And most probably are.

Another is that if the environment remains OK for corporate credit, then it shouldn't be terribly hostile to equities. J.P. Morgan noted last week that the forward "earnings yield" of the Standard & Poor's 500 based on current forecasts is 8.1%, while high-yield bonds were at 8.3%—the narrowest spread in history (it has averaged 5.1% since 1987).

Telling a similar story in a different way, the dividend yield of the Dow Jones Industrial Average components, at 2.65%, is essentially equal to the 10-year Treasury yield. The folks at Morgan Stanley note that over the past 50 years the Dow's yield has exceeded that of the 10-year Treasury for only one period—the end of 2008 into early 2009, as the financial crisis climaxed.