Saturday, March 22, 2008

Bond Yields as a Sentiment Gauge

Here's a weekly chart going back to the 2000 lows in the municipal bond market. We're looking at Vanguard's Intermediate-Term Tax-Exempt Fund (VWITX). According to the Vanguard site, the fund is currently yielding 3.67% on bonds with an average maturity of 7.1 years. About 87% of the holdings are rated AAA or AA. When we compare the tax-free yield of 3.67% with the yields offered on taxable certificates of deposit, the muni rate is quite attractive. Nationally, we're seeing average 5 year CD rates of 3.29%, according to Bankrate.

So what we have is one of two things:

1) A pricing anomaly that is a reflection of overblown fears of municipality vulnerability and monoline insurance fragility;

2) An accurate discounting of increased muni defaults in the face of plunging housing values, a weakening economy, reduced tax receipts, etc.

When muni rates for VWITX rose over 4% earlier this month, we saw investors snap up the attractive yields. A similar pattern occurred across the other funds I investigated. We remain well above the price lows from early March, though yields remain historically high relative to those available from Treasuries. By way of comparison, the Vanguard Intermediate Term Treasury Fund (VFITX) averages a maturity of six years and is currently yielding 2.79%.

The risk premium built into the munis is also evident among other bonds. For as close to an apples-to-apples comparison, I took a look at Vanguard's Intermediate-Term Investment-Grade Fund (VFICX). It has an average maturity of 7.8 years and over three-quarters of its holdings rated A or above. The most recent posted yield is 4.97%--again notably higher than the yields on Treasuries or bank CDs. It's interesting to note that VFICX is also trading above its recent lows, as yields over 5% found investor interest.

We saw harrowing declines in both munis (VWITX) and investment grade bonds (VFICX) in 2000, reflecting similar fears of default. Those bond markets recovered sharply well in advance of the stock market lows, reflecting reduced fears in the face of Fed easing. We're now getting significant Fed easing and bonds are off their highest yields. That has me looking for evidence of continued confidence among bond investors to see if the Fed's ministrations can help these markets turn the corner now as they did in 2000.

In that sense, these bond markets are excellent sentiment gauges. If the Fed's actions bring stability and confidence to the financial system, these yields should be very attractive and attract continued buying. If, however, we see sustained risk premia and even worsening bond prices in the face of aggressive Fed actions, then we have to look at the real possibility that these are not pricing anomalies and, instead, reflect anticipations of much worse things to come for debt issuers.


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