After suffering their worst year in decades in 2008, the entire gamut of speculative and investment grade bonds have posted big gains since the March 9 intermittent bear market low.

Credit spreads or the yield differential between benchmark U.S. ten-year Treasury bonds and speculative debt has crashed over the last eight weeks as risk returns to the fixed-income market. Spreads for investment grade bonds have also narrowed sharply – led mainly by a huge compression in bank-issued bonds.

In 2009, the S&P 500 Index is basically unchanged while the Barclays Aggregate Bond Index (includes all bond categories) has risen 1.4%.

U.S. investment grade corporate bonds, as measured by the Barclays Capital Corporate Bond Index, have gained 3.5% in 2009. Mortgage-backed bonds (Fannie, Freddie, Ginnie Mae) have climbed 3%. Municipal bonds have also enjoyed big gains with a 5.8% rally. The best-performing fixed-income category, however, belongs to high-yield or junk bonds, up 21.3%.

And as risk returns to the markets this spring investors are dumping Treasury bonds – clobbered since April. Intermediate-term Treasury bonds are down 2.4% this year while long-term bonds – the most sensitive segment of the yield curve to interest rate expectations – have plunged 11.6%. Treasury bonds are suffering their worst year since 1994.

For the first time since the start of the credit crisis my fixed-income indicators have now turned bullish. Though several important hurdles remain for a complete credit healing to occur, critically important short-term credit spreads have dramatically improved since March.

The short-term credit spread segment has rallied sharply since April with the TED Spread heavily compressing and now trading below 1%. The same is true for 90-day LIBOR or overnight dollar rates in Europe, which are responsible for setting more than $300 trillion dollars’ worth of global loans and funding requirements. LIBOR fell below 1% last week and is trading at just 0.85% this morning; LIBOR peaked at 4.82% last October.

To be sure, the riskiest segments of credit are now extremely overbought. Junk bonds, literally a trap for speculative investors as default rates continue to rise this year, have now gained more than 20% since late March. I continue to recommend avoiding the junk or high-yield sector as defaults have more than doubled since Q4 2008.

Risks, however, remain.

Several important credit markets have not shown the ability to trade without the Fed’s assistance. Banks that have raised capital without FDIC guarantees recently are still paying big premiums to raise financing. Also, the important mortgage-backed market is now witnessing a spike in rates – bearish for housing and refinancing activity. The Fed has already committed more than $300 billion dollars to mortgage-backed securities since November and is losing control of the fight to keep mortgage rates low. Though the current spike isn’t large, the trend is running in the opposite direction of the Fed’s target -- critically important since it affects consumer loans.

Another segment of the yield curve in trouble is the intermediate to long-term Treasury bond market. Interest rates have risen sharply since late March on the heels of “green shoots” appearing in the U.S. economy, rising inflation concerns and a recent poor auction of 30-year Treasury bonds last week. U.S. Treasury supply is estimated at $2 trillion dollars in 2009 – more than the combined issuance from 2006 to 2008.



With global capital markets now drunk with gains since March now is not the time to lunge after risk. This also applies to bonds, especially junk bonds. My focus this summer is to keep liquidity high ahead of another correction. Ironically, despite a deluge of issuance ahead of us over the next 12-18 months in the United States and Europe, government debt at the short end of the curve looks attractive. This is especially true if stocks correct this summer; investors are barely compensated in 90-day T-bills but can get about 1% on a two-year note, which trades just below par.

Stocks and speculative grade bonds have come a long way since March. If you subscribe to the view that this is a bear market rally then avoid chasing the short-term trend. The fundamentals for sustainable long-term domestic consumption in the United States remains bearish as the savings rate continues to rise while virtually every industry forfeits raising prices this year amid a deflationary environment. Don’t chase risk at these levels.

Have a good weekend. See you on Monday.