While the stock market receives most of
the attention in the daily news, recent bond market events are actually more
noteworthy in the severity of their dislocation. I'll avoid getting
technical with you, but two sections of the bond market aptly demonstrate how exceptional 2008 really was.
Municipal bond / Treasury ratio:
Municipal bonds are issued by states,
cities, counties, etc and their income is generally tax free to the owner
of those bonds (There are technicalities, but we won't cover them here and
they don't alter the data presented)
Since the interest is tax free and
municipalities hold the power to tax, yields are usually lower than US
treasuries of the same maturity. While there is the possibility of default on a
municipal bond it is generally low.
As you can see from the graph below,
2008 was a bit different than usual. The graph is the ratio of high
quality municipal bonds to US Treasury yields of the same approximate
maturity. A number of 90% would mean municipal bonds provide a yield
of 90% to Treasuries.
Before 2008 municipal yields almost never traded with a higher yield
than treasuries, and with good reason. For a little credit risk you were
well rewarded when the muni / treasury ratio went above 100%. As of
December 2008 the ratio was well above 170%!
Like many other ideas pushed too far, hedge funds were created to
extract excess returns from this relationship. Add too much leverage
and a severe market stress and you see what happens. As prices
dropped on municipal bonds to extreme levels, more hedge funds were forced
to sell, creating a vicious downward cycle
The case can be made municipal bonds deserve to trade at a higher yield
right now due to the risk of default by the underlying city / county /
state but nearly double the usual yield is a bit extreme.
TIPS (Treasury Inflation Protected Securities):
TIPS (Treasury inflation protected securities) are a bit more esoteric
but also show the recent market dislocations. The chart below has 3 lines: 10 year, 10 year TIPS real, and Breakeven
Inflation. 10 year is the yield on the 10 year Treasury
note. 10 year TIPS real is the real yield provided on a 10 year
TIPS bond from the US Treasury. The TIPS provide a yield of (inflation + a fixed percentage, the 'real
Subtracting one from the other gives you the Breakeven Inflation,
or the markets expectation of the inflation over the next 10
years. As you can see from the green line, Breakeven Inflation
wandered above and below 2% until 2008. While this graph does not
show it due to using monthly average data, at one point Breakeven
Inflation was zero, and on shorter term TIPS it was actually
negative! Short term deflation is possible but over the long term is
very unlikely considering monetary policy and US Government long term liabilities.
Other sections of the bond market are also at
extremes but I
think the two graphs above neatly describe how radically disjointed up the markets are
right now. They are slowly healing themselves right now but it
will take some time, and provide opportunity.
Similar graphs can be produced for the stock market but the multiple
factors inherent in stock prices reduce their clarity in showing how out
of wack the markets are right now.
The good news:
These extreme outliers are good for us long term.
Until 2008 most
financial models did not include financial shocks as severe as the one we
are in right now. The models did not account for enough
risk For a very long time banks, corporations and investors
will ask 'How would a 2008 event affect our
portfolio?' Supposedly 'safer' investments should
more secure and riskier assets may be underpriced for some
time. Underpriced risky assets are a benefit. Properly
identify those risky assets with improving fundamentals and you will be