Bonds Soar to Rare Heights

Yields on investment grade bonds have shrunk to less than 4%, the lowest level in more than 6 years, and just 1.7% points above treasuries (see front page article on the WSJ – “Bonds Soar to Rare Heights”). In a sign of the times, McDonalds raised $450 million in 10-year debt at 3.5% this week, a record low yield for a US corporate borrower for at least 15 years. Commonweath Edison Co., the electric utility owned by Exelon, sold 4% mortgage bonds at the company’s lowest 10-year coupon since the 1950s.

While concerns of a double dip recession and the reemergence of deflationary fears continue to gain more traction, I believe the stampede into credit will have profound consequences if sustained for much longer.  Committing new capital to fixed income at today’s paltry yields could only be justified if one believes we are heading for a Japanese style debt deflation. While I am staying on the sidelines (though maintaining a position in some floating rate debt funds), clearly I am in the minority given the billions of dollars of new money flowing into fixed income funds each week.

Anybody skeptical that the Fed would tolerate a bout of severe deflation should read comments out this morning from James Bullard, the President of the Federal Reserve Bank of St. Louis. Here is a snippet from a research paper released today.


“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released today about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

Another Solid Month for California Housing Market

While housing activity on a national basis has declined sharply over the last few months due to the expiration of the $8,000 new homebuyer tax credit, California data for the month of May continues to reflect steady improvement. Given that California led the rest of the country into the housing downturn, it is encouraging to see the region showing concrete evidence of a bounce off the bottom. Notwithstanding the encouraging data from May, June and July will likely show a falloff in activity (similar to the rest of the country), but it is important to put in context the level of healing that has emerged over the last year (see accompanying charts for evidence). Barring a significant decline in the economy, it seems highly unlikely for California to retest the lows in activity and pricing that reflected the state’s housing market in the dark days of early 2009.

As indicated in the chart below, May home sales in Southern California were up 7.2% year-over-year with Los Angeles, Orange County, and San Diego up 12.3%, 22.1%, and 19.6%, respectively. Unit prices were also strong, up 22.5% year-over-year and 7% vs. April 2010. Since bottoming in April 2007 at $247,000, median home prices in SoCal have risen by 23.5% to $305,000. Though prices have risen smartly off the bottom, they are still down 40% from the peak, with pricing in the inland empire down well over 50% off the top.

Similar to Southern California, the Bay Area continues to show significant evidence of a rebound. May home sales were up 11% year over year, with the higher end regions (San Fran, Marin County, Santa Clara) up well over 20%. The trends in pricing were even more encouraging, with prices up 20.1% year-over-year and up 10.8% vs. April. Since bottoming in March 2009 at $290,000, home prices have risen by a sharp 41.4% to $410,000 in May 2010. While mix has undoubtedly padded that figure, all regions tracked by Dataquick have seen pricing up by double digits off the bottom.

Illinois Stops Paying its Bills

Here is a must read article from the NY Times ("Illinois Stops Paying Its Bills, but Can’t Stop Digging Hole") that highlights the fiscal mess brewing in Illinois.  The mounting deficits facing most of our states (with California, NY, and Illinois being the most egregious) presents the gravest threat to the long-term health of our country.  Anyone holding muni bonds in their portfolio should think long and hard about the wisdom of this decision after reading the linked article.

Here are some of the key paragraphs from the article:

For the last few years, California stood more or less unchallenged as a symbol of the fiscal collapse of states during the recession. Now Illinois has shouldered to the fore, as its dysfunctional political class refuses to pay the state’s bills and refuses to take the painful steps — cuts and tax increases — to close a deficit of at least $12 billion, equal to nearly half the state’s budget.



Then there is the spectacularly mismanaged pension system, which is at least 50 percent underfunded and, analysts warn, could push Illinois into insolvency if the economy fails to pick up.


States cannot go bankrupt, technically, but signs of fiscal crackup are easy to see. Legislators left the capital this month without deciding how to pay 26 percent of the state budget. The governor proposes to borrow $3.5 billion to cover a year’s worth of pension payments, a step that would cost about $1 billion in interest. And every major rating agency has downgraded the state; Illinois now pays millions of dollars more to insure its debt than any other state in the nation.

The state pension system is a money sinkhole and the most immediate threat. The governor and legislature have shortchanged the pensions since the mid-1990s, taking payment “holidays” with alarming regularity.



The state’s last elected governor, Rod R. Blagojevich, is on trial for racketeering and extortion. But in 2003, he persuaded the legislature to let him float $10 billion in 30-year bonds and use the proceeds for two years of pension payments.


That gamble backfired and wound up costing the state many billions of dollars. Illinois reports that it has $62.4 billion in unfunded pension liabilities, although many experts place that liability tens of billions of dollars higher.