Investors, seeking higher returns have moved more and more into securities that have higher yields putting aside, for the time being, the issue of credit risk.
To see a list of high yielding CDs go here.
In a period of time like the last several years when the Federal Reserve has been conducting a policy of quantitative easing, the credit risk factor has not been considered to be that much of an issue because the Fed has been pouring so much money into the economy. The downside risk connected with credit has been felt to be minimal.
Now, however, the Federal Reserve is projecting rising interest rates in the future…although not right-around-the-corner, and if this is going to be the case, investors will begin to worry a little more about credit risk.
Hence, when interest rates do rise, this would mean that the yields on less credit worthy bonds would rise more quickly than would the yields on more credit worthy issues. And, since the price of bonds moves in the opposite direction of yields, this would mean that the prices of the less credit worthy bonds would fall much faster than would the prices of the more credit worthy bonds.
One way to look at the relationship of yields in the bond market is to use the figures on market yields published weekly by the Federal Reserve System. The specific release is the Fed’s H.15 release which can be found on the website of the Federal Reserve.
The three yield categories I look at are those for the 10-year constant maturity Treasury bond, and the yields on Moody’s Aaa and Baa corporate bonds. In order to analyze the relationship between the various yields I calculate two numbers: the ratio of the Treasury bond yield to Moody’s Aaa corporate bonds; and the ration of Moody’s Aaa corporate bonds to Moody’s Baa corporate bonds.
Each ratio measures how close the more credit worthy and the less credit worthy trade. As either ratio approaches 1.00, the closer are the two yields from each risk class.
In terms of interpretation, I refer to the ratio between the government bond yield to Moody’s Aaa bond yield to as the liquidity ratio because it tends to pick up how liquid the market is.
For example, when the crisis in the financial markets of Europe was taking place, lots and lots of risk averse money left Europe and came to the United States seeking a “safe haven.”
As the money flowed into the United States in the last two quarters of 2011, the liquidity ratio fell and reached a low of .475 in the third quarter of 2012. The 10-year bond yield reached to a low of around 1.50 percent in July of the year.
The trough in this measure came in November of 2012, the month I measure, by other statistics, the end of massive flows coming into America.
During the first half of 2013, the bond markets were relatively calm, even though money started to flow back into Europe. The liquidity measure rose to around .600 by the end of the year and the 10-year bond yield rose to around 3.00 percent.
The interpretation of the liquidity ratio at this time was that there was lots less liquidity in the bond markets that were flowing into Treasury issues and with this outflow of liquidity, the yield on Treasury issues rose relative to the yields on Aaa-rated bonds.
The second measure, the ratio of the two yields computed by Moody’s, is referred to as the confidence index. As confidence rises in the bond markets, the yield on the Baa-rated bonds drops relative to the yield on Aaa-rated bonds. In other words, the riskier Baa-rated bonds are felt to possess not as much credit risk and so the yield on the bonds falls relative to the yield on the less risky bonds.
During the 2011 to 2013 period just discussed, the confidence ratio dropped along with the liquidity ratio. It seems as if all the “risk averse” money flowing into the United Stats was going into the top quality securities and that the Aaa-rated corporate bonds were benefitting from the inflow although not as much as the Treasury issues.
The confidence ratio hit a low in the third quarter of 2012 of just under .710 at the same time that the liquidity ratio bottomed out.
The interesting thing is that as money flowed out of the United States the confidence ratio rose in tandem with the liquidity ratio. The yields on the Treasury issues and the Aaa bond issues rose as the yields on Baa bonds stayed relatively constant. Even though liquidity was leaving the market, the confidence ratio indicated that there was sufficient confidence in the market so that the Aaa yields rose faster than did the Baa yields. This just shows the distortion the flow of funds from Europe caused the American bond market.
Since the third quarter of 2013, the liquidity ratio has remained relative constant in the .600 to .625 range. The argument that can be made here is that the Federal Reserve is bringing to an end its policy of quantitative easing. This may result in the liquidity ratio either remaining constant or rising some. This would not be a bad thing, but would give us an indication of where investors were in terms of the Federal Reserve not being as generous in supplying reserves to the banking system as it has over the previous couple of years.
On the other hand, the confidence ratio has risen dramatically. Ever since the third quarter of 2012, the confidence ratio has been rising. In the third quarter of 2014, the confidence ratio stayed within the .840 to .880 range. That is, Aaa yields have risen from about being 70 percent of Baa yields to where Aaa yields were almost 90 percent of the Baa yields.
This represents a tremendous market confidence as more and more money flowed into lower credit worthy bonds chasing yield. Investors seem to be saying that the Federal Reserve will remain loose enough and longer-term bond yields will not rise much in the near-term so that they feed confident that they can place their money in the higher yielding bonds and not be overly concerned.
This is something to watch. In the last three weeks, the confidence ratio began to decline, dropping to around 86 percent in the week ending September 19 to around 85 percent in the week ending September 26 to around 84 percent in the seek ending October 3.
The bond market seemed to be relatively choppy during this time and this decline may be some indication that some investors are getting a little nervous about the direction interest rates are going to go.
Investors are concerned with what is going to happen with yields when the Federal Reserve allows interest rates to begin to climb. The measures that I have discussed in this post can perhaps provide some idea of the direction the markets are moving and can be used to help interpret that movement. Although one must be careful about the interpretation, the measures do provide some information that can be useful in crafting a better understanding of the market.
About John Mason John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.