Bond Rally Cracking?

Posted by urbandigs

Tue Nov 30th, 2010 08:56 AM

A: We have seen it a few times, with Greece and now Ireland, as worries infect the impenetrable bond rally as money searches for yield. But now, its hitting corporates as well as Italian and Spanish bonds. Its worth keeping an eye on because of the unstoppable rally we have seen in both equities and high yield. Fixed income lately has seen some cracks, especially in the munis. But is this it? Is the game over?

Well, good times last until they don't. Its quite challenging to time perfectly especially since markets are not rational and can stay irrational for way longer than any one speculator can stay solvent. But the warning signs are flashing again (munis, sovereigns) and if it continues, equities could see a sizeable correction. Lets get to the news first:

Via Bloomberg, "Italian, Spanish Government Bonds Plunge, Sending Spreads Wider":

Italian and Spanish government bonds slumped, driving the extra yield investors demand to hold the securities instead of German bunds higher, as Europe's debt crisis intensified.

The drop pushed the yield spread between 10-year Italian securities and similar-maturity German debt to more than 2 percentage points for the first time since 1997. Spanish bonds fell yesterday by the most since the start of the euro era as a bailout for Ireland failed to assuage speculation that the debt crisis will spread. The cost of insuring the debts of Italy, Spain, Portugal and Ireland surged to records and the euro slid.
Munis saw a very volatile month with a sharp selloff a few weeks ago. The reports, "Muni Tumult Ends a Fund-Inflow Streak":
The price volatility in the muni market was compounded by the effects of the Federal Reserve's bond-buying efforts, which have driven the yields on 30-year Treasurys higher. Rates on long-term municipal debt generally move in sync with long-term U.S. Treasurys.

Also, some individual investors have been spooked by news of the fiscal strain facing states and cities that issue the bonds, says Guy Davidson, who oversees about $30 billion in muni bonds at AllianceBernstein. The magnitude of the outflows "just speaks to how nervous people are," he says. Mr. Davidson, however, believes the recent muni-bond selloff was driven primarily by the surge in supply, not concerns about the ability of municipalities to repay their debt.

"Retail is doing what retail always does," says Hugh McGuirk, head of T. Rowe Price's muni-bond team. "Once you get a little price movement in one direction, retail [investors] tend to chase performance or move out of the funds that are going down."

Muni-bond prices began to recover slightly late last week.
Herds rule the markets and the herd has tons in the highest yielding asset classes. Selling causes volatility, losses, and triggers more selling. Its a negative feedback loop and we never know when its going to fade on its own or build into something bigger and badder. Thats why we should keep our eyes on it when the warning signs flash. Will concerns really hit the corporates and junk? I still worry about how this world will adapt if/when the selloff in bonds sustains itself, causing borrowing rates to surge. This end game is being delayed by fed engineering and government backstops. Ill end this piece the way I started it --> the good times last, until they don't.