This from Sovereign Society:

Several segments of the credit markets have come back to life in December after crushing losses recorded in September and October. Though it’s too early to celebrate a broad-based credit revival, the largest issuers of investment grade debt surged this month as yields plunged. Mortgage-backed bonds, or agency debt, have also rallied sharply in December on the heels of government guarantees and the Fed’s plan to spend $500 billion dollars to shore up the sector.

With the United States and other governments amassing a truckload of debt to finance state sponsored bailouts of financial services and fiscal spending plans, it is conceivable that investors will increasingly swap low-yielding T-bonds for high quality corporate debt in 2009.

Since hitting a post-crisis peak of 4.88% in October, three-month LIBOR (London Interbank Offered Rate) has plunged to 1.52% on December 19. On December 1, LIBOR stood at 2.22%. A lower LIBOR rate is the first indicator to finally emerge from stress amid the credit crisis. Banks are still largely hoarding cash but several large institutions have started to lend in overnight markets this month for the first time since late 2007.

The Growing Yield Dilemma

The Federal Reserve’s latest interest rate cut to effectively 0% on December 16 has laid the foundations for more trouble at money-market funds where yields for 30-day and 90-day Treasury bills continues to fetch just 0.01% – the lowest in more than six decades. Earlier in December, 30-day bills actually turned negative for the first time since 1940. That means investors are paying the government to park cash.

Money market funds are now sitting on potential losses as management fees erode the yield generated by Treasury bills and other short-term paper. Though other debt securities yield more than T-bills, investors might be embracing more credit risk as fund companies look to boost yield.

A better alternative to money market funds include one-year term deposits (CDs), short-term investment grade bonds and even intermediate-term corporate debt. Term deposits should be held only at the nation’s biggest banks, including J.P. Morgan Chase, Wells Fargo and Bank of America.

Yield Hungry? Here’s a Free Lunch

The Fed’s latest moves to spur lending in a massively credit-inflicted bear market since 2007 is forcing many investors to turn to distressed corporate investment-grade bonds. The effective yield on the benchmark Dow Jones Corporate Bond Index is 7.23%, down from a record high of 8.88% just a few months ago and down from 8.06% on November 30. A lower yield means corporate bond prices are rising in value.

In September, investment grade bonds were hammered following the collapse of Lehman Brothers Holdings and posted their single worst month of performance since February 1981. Many bonds plunged more than 15% in September alone.

More than half of the investment grade bond sector is comprised of financial services debt or bonds issued by some of the largest banks in the United States and Europe. With the Fed’s implicit guarantee on the largest issuers of such debt, investors can now tap into bank issued bonds trading at a 5.16% premium to expensive Treasury bonds.

For a portion of an investor’s liquidity, corporate high quality debt is literally a “free lunch.” The largest issuers of corporate paper have started to return to the market since November, including IBM and other large cap companies. In Europe, some banks without government guarantees have managed to raise sizable offerings – a positive development.

Corporate Debt: The New Safe-Haven?

Since October, governments in the United States and Europe have swapped government paper for toxic mortgage-backed assets previously held at banks. Despite these efforts, most banks are still laced with all sorts of other clogged credits like leverage loans, auction rate securities and repo credits.

The credit crisis has not disappeared because of aggressive government and central bank action; rather, swaths of credit risk has been transferred from bank balance sheets to government balance sheets, effectively polluting central bank coffers with largely illiquid and near worthless paper. Since August, the Fed’s balance sheet has mushroomed from $850 billion dollars to more than $1.5 trillion dollars – and still rising.

Indeed, credit default swap rates since October have risen sharply on government paper while swap rates have decreased for the highest quality companies. This suggests investors are starting to place a risk premium on government issued bonds.

Are we at the cusp of a major transition in the credit markets whereby investors might increasingly purchase investment grade debt as a hedge against rising yields on government bonds? After all, outside of the financial sector many industries harbour their highest net cash levels in more than a decade. For some companies, especially the food and beverages and fast-food companies, cash flow is largely generated internally and, in most cases, these companies don’t need to raise cash to finance operations. I would argue that companies like Kraft Foods (NYSE:KFT), General Mills (NYSE:GIS) and McDonald’s (NYSE:MCD) are a better long-term credit risk than most sovereign borrowers.

Failed Auctions Rising

To confirm the above theory that perhaps investors are starting to embrace riskier bonds like investment grade debt because of bulging government deficits, consider the trend in Europe since October whereby several governments have scrapped bond auctions.

Over the last sixty days, Germany, the Netherlands, Italy, Spain, Austria and the United Kingdom have either scrapped bond auctions or reduced their planned offerings because of tepid investor interest. These governments, including Germany, the largest and most liquid, are paying higher yields to draw institutional buyers. This could mark the beginning of a bear market for government bonds at some point later in 2009, once credit markets stabilize and risk taking is resumed.

In the United States, demand for Treasury’s remains strong because of fears of deflation. The current environment – a disaster for just about every asset class except T-bonds – has supported the dollar to an extent. Foreigners are chasing Treasury securities as they scramble for safe havens. Yet even Treasury is not immune to the deluge of supply coming our way in 2009.

Over the next 12 months Treasury estimates it will have to raise about $1.5 trillion dollars to fund gargantuan fiscal spending plans, bailouts, and possible tax cuts. Treasury will re-introduce one-year, three-year and five-year T-bonds in 2009 to finance part of this spending spree. At some point, investors will force long-term rates higher. The Fed will try to influence the long end of the yield curve but will ultimately be unsuccessful. The Fed can only control short-term lending rates.

Investment grade bonds shouldn’t supplement T-bills. The risk spectrum is normally quite significant in a normal economic environment. Yet these are anything but normal economic times. It is possible that as 2009 progresses and, assuming credit markets continue to grudgingly normalize, the new safe haven in bonds will be high quality investment grade bonds at the expense of super low-yielding Treasury debt.

Source: Is Investment Grade Corporate Debt Safer Than Government Bonds?

This from Sovereign Society:

“This aging stock bull market is looking increasingly like a scarred prizefighter after winning too many championships. Indeed, the market is looking increasingly fragile, bruised and battered since the bear market low in October 2002.”

In January 2008 I made the above observation about stocks as the market was coming undone. Of course, almost a year later the stock market has collapsed with stocks likely to post their worst calendar year of performance since 1931. Over $10 trillion dollars of global stock market values have been wiped-out in 2008.

So is it time to start looking at stocks again? Despite several bottoms over the last 14 months, can we expect stocks to finally form a meaningful rally? From their lows on November 20, stocks have now gained 10%.

Indicators Flash “Buy”

Many market indicators I track are flashing “Buy” since late November. These include high institutional and hedge fund cash levels, extremely bearish investment advisor sentiment readings, big dividend yields for many global markets in excess of benchmark ten-year government bond yields, and a rash of hedge fund closures and failures.

Also, individual investors have been dumping stock funds like crazy since July with record net outflows over the last five months and the VIX Index (CBOE Volatility Index) remaining highly elevated amid total fear in the market.

Stock market valuations, though not dirt-cheap are certainly looking far more attractive compared to just 12 months ago.
Valuations and dividend yields, which can typically point to either an over-extended or undervalued market, now show fair value for U.S. stocks and high value for European, Asian and emerging market equities following even bigger declines for these markets.

Stocks in Europe yield 5.9% and in Japan the TOPIX (the country’s broadest stock index) pays a 3% dividend…the highest in more than 28 years. Indeed, compared to stocks, government bonds are richly valued and pay the lowest yields in years and in some cases, decades.

Explosive Bear Market Rally Coming

I’m certainly not bullish by any means. The long-term implications of mass government intervention, widespread regulation and control of several important industries (including finance) won’t encourage bold risk-taking for a long time. Credit markets are grudgingly healing, banks largely won’t lend and TARP and TALF-sponsored government programs are taking too long to filter through the economy.

There is absolutely nothing in the cards to suggest a new bull market is on the horizon.

But like the 1930s, the stock market can post a major short-term reversal and shock the bears with big double or even triple-digit gains. It’s hard to say what might trigger a major reversal. Obama’s inauguration in January, lower LIBOR and inter-bank lending rates or possibly a weaker Japanese yen might offer such a catalyst.

The last credit crisis of this magnitude occurred in the 1930s. Judging by trends during that tumultuous era, stocks can indeed post some huge gains even in a bear market. For example, from its lowest point in June 1932, the Dow Jones Industrials surged more than 162% twelve months later. But by 1937, the Dow began crashing again, plummeting 55% and losing another 28% in 1938 before finally bottoming in 1942.

After crashing more than 45% off the October 2007 all-time highs, U.S. stocks might be attempting to finally muster a bottom. Any rally, however significant, should be viewed in the context of a secular bear market; the badly shattered economy is in no condition to build on a sustainable long-term rally like the 1990s or 1980s.

New Market Leadership: Go for Credit

Ahead of the upcoming bear market rally investors will have to find new leadership. It’s highly unlikely that energy stocks or emerging markets will lead any recovery, however short-lived. Instead of riding a frantically erratic stock market that continues to trade at near-record volatility levels, I would encourage investors to begin accumulating long-term positions in busted credit markets.

The epicentre of this financial crash lies in the distressed credit market – and that’s where investors should focus their buying strategies. Income is vital right now.

The entire spectrum of non-Treasury securities has been crushed since September, including investment-grade corporate bonds, convertible bonds, mortgage-backed agency debt and TIPs or Treasury-Inflation-Protected Securities. Emerging market bonds, municipal bonds and junk debt or high-yield bonds have been slammed even harder. But they should still be avoided as defaults, failed auctions and currency issues plague these credits.

But several other areas of credit look highly compelling.

Investment-grade bonds, for example, plunged to their lowest levels since 1981 in September and yield 8.38%, according to the Barclays Capital U.S. Corporate Index.

I don’t know about you, but a 7-8% yield today looks mighty appealing. And looking back at the bear market rallies of the 30’s, it’s clear that most investors won’t get off the bus before equities begin crashing again. Despite the seemingly terrific trading opportunity in stocks, it’s still just too volatile out there.

High-grade corporate debt at least offers the investor a combination of above-average income, the spectre of capital gains at these low prices and in some cases, implicit government guarantees on bank debt and agency bonds, which still yield about 5.5% or more compared to expensive Treasuries.

Nobody can claim that corporate bonds, agency debt or convertible bonds have truly bottomed after more than 16 months of utter panic and several crashes. Yet as value investors, this is precisely the time to start purchasing these distressed securities.

Doing so will at least allow conservative investors to ride out a harsh cycle, instead of buying the top during a bear market rally and getting burned as stocks crash lower. Best of all, those juicy yields and bombed-out prices should eventually translate into impressive double-digit gains for investors…regardless of where stocks trade.

Source: Focus on Busted Credits and High Income in 2009