Jim Grant in the Financial Times

I saw references to his recent article in the Financial Times but haven't seen it being re-produced in full anywhere (you have to pay to view on the FT site) except at Jesse's Cafe Americain (skip to the middle of this blog entry; I am not familiar with this blog.) Grant covers his latest thinking, which is essentially a bearish view of US Treasuries and a bullish view of corporate and mortgage bonds.

(source: Insight: Return-free risk by James Grant. Financial Times. December 4 2008)

US Treasuries are the investment asset of the year. The less they yield, the more their fans adore them. Then, again, these fearful days, yield seems to have nothing to do with investment calculation. Purported safety is all.

“Super-safe Treasuries”, the papers call these emissions of a government that, this year, will take in $2,500bn but spend $3,500bn. “Toxic assets” is how the same papers characterise orphaned mortgage-backed securities—or, for that matter, secured bank loans, convertible bonds, junk bonds or almost any other kind of debt obligation not bearing the US imprimatur.

Grant summarizes the present situation, which amounts to super-low yields for US Treasuries while non-government bonds have ever-rising yields.

I see quite a few contrarian small investors, at least the ones on blogs/message boards/etc, starting to think about taking a bearish bet on US government bonds. You can try shorting the bonds or the long-only ETFs/CEFs; or go long one of the inverse/short ETFs (one can also use derivatives such as buying put options on the long-only ETF or selling call options on the long ETF). I think this is a risky call. If you mistime it, it will end up being a poor investment. More preferable is to consider some of what Jim Grant or others say and go long non-government bonds. In other words, taking a bearish position on US government bonds is much tougher to execute properly than taking a bullish position in non-government bonds.

In corporate debt and mortgages, anomalies and non sequiturs abound. They are especially prevalent in convertible bonds. More so than even the average stressed-out fund manager, convertible arbitrageurs have been through the mill. It was they—and almost they alone—who owned convertibles. Now many of these folk must sell them.

That's an insightful thought that never crossed my mind. That is, convertibles may be even more depressed than other assets given that risk arbitrageurs were the big players in that market (and these players are being forced to exit the market.) I'll try to concentrate on convertibles and see if I can dig up any attractive ones.

Don't forget that convertibles are the ideal investment if you are bullish. They give you the upside of stocks whereas straight bonds or preferred shares have maximum upside. One negative regarding convertibles is that they are more complex to value.

Grant gives an example of the dislocation in the convertible market:

Thus, at the end of October, a Medtronic convertible bond with a 1.5 per cent coupon with the debt maturing in April 2011 briefly traded at 80.75. This was a price to yield 10.6 per cent, an adjusted spread of 1,600 basis points over the Treasury curve (adjusted, that is, for the value of the options embedded in the convert, notably the option to exchange it for common stock at the stipulated rate). Contrary to what such a yield might imply, A1/AA minus rated Medtronic, the world’s top manufacturer of medical devices for the treatment of heart disease, spinal injuries and diabetes, is no early candidate for insolvency. Almost every day brings comparable examples of risks not borne by people who, in this time of crisis, have come to define risk as “anything not guaranteed by Uncle Sam”.

Unless you really like Medtronic, that yield is too low for someone like me (it might be great for a bond investor though.) I would rather move up the risk chain and look at non-investment grade companies. I personally think an area worth looking at is the various commodity industries, such as the base metal miners, oil&gas, and so forth. I'm somewhat bearish on commodities but even then, if you can find a solid company that will survive at current (or slightly lower) prices, it is worth looking at. The only potential problem with this commodity idea is that the market is still way too bullish on them so prices may not be good enough yet.

“Risk-free return” is the standard tag attached to the government’s solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description – “return-free risk”.

LOL :)