How Friday's Selloff Affects Bonds

I had planned to write a boring column on where potential inflation could come from, but with today's volatility that seemed a little out of step. So here are observations on what is happening in bonds, as well as how I'm investing now. How Bad Are Credit Bonds? The junk bond exchange-traded funds are down 2%. The High-Yield CDX index is down 1.5%, setting a new year to date wide on spreads. Today definitely has a different feel. News that Third Avenue Management was gating its Focused Credit Fund has gotten a lot of headlines and likely contributing to the pressure the last two days. The fund will be liquidated over time. This is definitely not your average junk bond fund, having fallen 25% since June. But this kind of thing happens when you mix poor fundamentals with terrible liquidity. Instead of the fund trying to manage through it, they have to gate the fund. I'm not worried about the direct fallout from Third Avenue's sales. But if this causes more selling of high-yield bond funds by retail investors into an already illiquid market, that could put even more pressure on bonds. The energy space, already under huge pressure, is falling off a cliff today. ConocoPhillips (COP) (rated A2/A) is 60 basis points wider (or about 6 points lower on the 10-year bond in price) over the last two days. Until now, the very high quality names had held in. On the week in CDS, Anadarko (APC) is 185 bps wider, Devon (DVN) is 150 bps wider, and Apache (APA) is 140 bps wider. In all three cases, the bonds are investment grade. In all three cases, this week's move represents roughly doubling of the bond's spread. It feels very much like a panic. More cyclical sectors that had been doing all right are starting to crack, too. For example, Dish Network (DISH) 5.875 '24 (rated Ba2/BB-) traded at $89.75 (spread of 519 bps) a week ago. Today traded at $85.125, or 80 bps wider in spread. Less cyclical sectors are very much a mixed bag. I would say that until today, if you were either a domestic consumer-based company or were otherwise less cyclical, your bonds hadn't moved much over the last six weeks. Take Royal Caribbean (RCL) 5.25 '22 (rated BB+, and one I happen to own). These bonds traded regularly in the low-mid $104s since early November, which was a spread in the +230 area. Now that spread has moved out to about +250, most of that happening today. That's a big one-day move, and I'm obviously happy to own this specific bond. But I wouldn't say bonds like this are real big opportunities quite yet. Bottom line: If you are willing to wade into energy or highly cyclical sectors, you might finally be getting your panic moment. We are looking at investment-grade energy names now. As I said the other day, make sure you know what you are buying. But outside of those sectors, opportunities seem idiosyncratic rather than general, even after today's big selloff. How Low Could Treasury Rates Go? The technicians are pointing out that the 10-year note moved through its 50-, 100- and 200-day moving averages in a single day. There are two things going on today putting downward pressure on Treasury yields. One is the risk-off move. But the other is news that China would be re-indexing its currency basket. The word on the street is that this is a prelude to more Market Vectors Chinese Renminbi/USD ETN (CNY) weakening, which should result in more demand for Treasuries. As far as what this means for yields in the coming days, we are sitting at a major resistance point at 2.13%. There is scope to get down into the 2.05% area, but not much below that. Sentiment is one-way on both the potential for inflation as well as the potential for more rapid Fed hikes. When sentiment is so one-sided, it makes a big rally harder to pull off. For example, CPI excluding food and energy is expected to be 2% year over year when it prints on Tuesday. If it is actually just 1.8%, that won't shock anyone. People already think inflation is mediocre. That wouldn't be enough to push rates below 2%. But if it print at 2.2%, that might cause investors to rethink the Fed's path. So, I like plays on Treasuries staying above 2%. You could do this with options on a Treasury ETF, like iShares 7-10 Year Treasury Bond (IEF). The 10-year trading at 2% would be roughly $108 on IEF. I am also buying mortgage-backed securities, especially ones that would be refinance-able if the 10-year got down into the 1.8% area. These have been trading poorly the last week and I have been expanding my holdings.

How Friday's Selloff Affects Bonds

Wading into energy, cyclicals and Treasury rates.

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