The Message from Corporate Bond Yields

Peter Bernstein, the New York economist, puts his finger on a challenge facing all investors today: what to make of the choice between corporate bonds and Government bonds? The difference in yields between the two clases of bonds is wider than at any time in our lifetimes. The spread between the two is several standard deviations above historical experience. What is more, the yields on corporates and Treasuries are moving in opposite directions, something which has rarely if ever happened before.

Peter thinks that this relationship is “fundamentally unstable” and must change, as do I. Of the two types of bond, it seems fairly obvious which looks the better bet. If you believe that we heading for a sustained period of debt deflation, you can just about make a case for owning Government bonds even at today’s extremely low yields. The 10-year US Treasury bond at 2.69%, notes Peter, is the lowest it has been since 1956. It does not look an attractive long term rate at which to lend money to a massively indebted Government.

But here is the sting in the tail. If we get an outcome as bad as sustained debt deflation, it would not take long for the perceived security of Government bonds to vanish. As Peter explains: “Ultimately the national debt depends upon the economy of the nation itself, which produces the tax revenues necessary to service the debt. The nation’s economy is what keeps Treasury debt from turning into a Ponzi scheme. In short government debt is riskless only when the nation’s economy is prosperous”. (Source: Economics and Portfolio Strategy; a subscriber publication).

Meanwhile the case for corporate bonds rests on the fact that a catastrophically bad economy and unprecedented default rates are already priced in at today’s yields. Of course investors will need to pick their corporate bonds with care to reduce the risk of default. As a class however, corporate bonds clearly have the edge over Government bonds. The only question now is how long it will take the investment community, prodded by the Federal Reserve’s zero interest rate policy, to realise the same thing.

Not long, I suspect.

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