Priced for Perfection

Well maybe not priced for perfection just yet, but getting pretty close. Most fixed income spread product, like mortgage backed securities, corporate bonds and asset backed securities, have performed admirably for the past 2 years. Those who put capital to work at the darkest of times were handsomely rewarded, but what will they do now and what will we do too? If the economy continues to recover along the same path as the past few months, you can still earn a decent return despite the drag from rising interest rates. As a spread to Treasuries, levels in many cases are reminiscent of 2007 before the financial world as we know it nearly came to an end. Across the pond, there is a mounting debt problem amongst European peripheral nations like Portugal, Spain and Italy. Economic growth in those countries has slowed while budget deficits have soared and investors have expressed reluctance to roll the debt. Portuguese debt is trading similar to US 'B' rated high yield bonds and on average Latin American USD bonds are trading well through the sovereign debt of these peripheral countries. Greece debt appears to be priced for a restructuring and Irish debt is following down a similar path. That turmoil overseas has not had a lasting impact on our markets, but merely has shaken them up from time to time as negative headlines surfaced. If a shake up occurs this year, it would provide an opportunity to add to positions. Another opportunity might occur if economic growth disappoints, as it is apt to do occasionally. Credit spreads are destined to go tighter over the course of the year but it is highly likely they widen at some point to provide a better entry point. The primary market for new issues is likely to be heavy and the economic recovery is not likely to continue in a perfectly straight path so look for periods of weakness in equities that may cause people to sell high yield funds as well. Emerging market debt looks pretty healthy as well, though Argentina appears to be overbought since it returned 38% to investors last year. Chile provides some interesting trading opportunities as the government's intervention efforts will have limited success in keeping the Chilean peso cheap to the Dollar. The country has wisely opted to buy $12 billion this year of Pesos in an effort to raise hard currency for a rainy day while pushing against the tendency of off shore investors to drive the Peso to an overvalued position. Venezuelan debt, yielding 15-18%, looks interesting but clearly you get what you pay for as that country's economy is arguably broken. In 2010, the debt of investment grade countries like Brazil and Mexico returned around 11% while junk rated Venezuela returned around 15% so on a risk adjusted basis investors were not paid well. Venezuelan bond supply was heavy last year, as it was in 2009, but we may have arrived at a virtuous period over the next 6 months when the country does not issue and allows its debt to perform like the high beta sovereign that it is, with tightening spreads in a bull market for credit as people grab for the highest yield they can find.