Exotic turns in the quest for yield

bond yields are paltry

The yield on the ten-year US Treasury bond is 2.74%.  The yield on the thirty-year Treasury is 3.9%.  The two-year note yields 0.46%.  In shorter-term instruments, your capital is safeguarded but you receive basically no income.

We know that income-oriented investors, both individuals and institutions, have been forced to search for yield elsewhere.  Year to date, the dollar value of new junk bond issues in the US has already surpassed the total for all of 2009–which itself was a record year for issuance.  High yield bond prices have already returned to the levels of mid-2007, before the financial crisis began to take its toll on valuations.  True, yield spread over Treasuries is more than 300 basis points wider today than then, but the two-year note was yielding about 4.9% during the summer three years ago (how quickly we forget!).

New issuance appears to be accelerating.

exotic alternatives

Two new, more exotic types of issue have begun to make the news recently.  I don’t pretend to be an expert on bonds, but in the stock market these would be signs that the market is topping.  They are:

the hundred-year bond Norfolk Southern recently issued, at a price of about 101, $250 million in 6% unsecured notes due in 2015.  Yes, they’re redeemable, but at the company’s option, not the holders.  No, they’re not secured by the company’s physical assets.  Yes, they’re very sensitive to changes in interest rates.  No, trading them won’t be easy.

the mandatory convertible General Motors is planning to issue one along with common stock in its IPO.  Details of the GM mandatory haven’t been announced, but the idea is that it will initially be a preferred stock yielding, say, 5%.  After some specified period of time (two years?) the security will automatically convert into being common equity according to a formula that will give holders some protection against a decline in the new GM shares, and the company some relief it its stock is very strong.

One notable feature of this mandatory is the pik (pay-in-kind) option.  That is, GM can choose to pay the dividend in shares of GM stock rather than in cash.

Put another way, GM will be giving you a 10% discount for agreeing now to buy common stock around the then prevailing market price two years from now.  GM wins if the stock is 10% higher then than now.  And you win vs. buying the common now, if …?

bullish for stocks

To me, this all means that silly season for bond investors is in full swing.  This development is ultimately bullish for stocks, I think.  If investors are willing to buy these exotic instruments, can the purchase of stocks–even regarded as a funny type of bond–be far behind?