Double Blind

The market for the fed funds futures for the end of 2010 is now around 1.45%; this is significantly lower than a month ago, when it peaked around 2.1%. I am relatively happy I closed my short-term interest rate bet when rates were higher.

My line of thought would suggest that 1% is a realistic short term rate, but this would only come in the form of quarter-point increases starting around the summer of 2010. 2% is pie-in-the-sky now, unless if there is some sort of collapse in confidence in the US bond market (which could happen, it is very difficult to tell these days if they are going to fall off a cliff financially).

I have been swinging back and forth on this issue like a pendulum simply because the economic variables coming in are incredibly fuzzy, but all lead to the conclusion that if the economy does recover, it will be a mediocre recovery at best.

This would suggest that inflation will not be a concern for the next year, plus rates should still be kept low. It is a very 1990′s Japan-like scenario. The only question is what will happen with commodity pricing and currencies – I still think oil consumption will rise over time, and this would suggest that oil prices would buck the overall trend economically. This would suggest a favorable lean toward Canadian-denominated issues, but again, the data is very fuzzy at this moment. The Canadian dollar might touch 80 cents again, although 83 cents seems a little more likely.

I have been on the record in thinking that short term crude prices have been somewhat high, and is likely due for some sort of correction around the US$50-60 range (from highs of $72.50 a month ago). When it has played out (which will be very difficult to determine at the time), it would likely be a good time to get back into crude-denominated debt issues. I’ve noticed some of my exchange-traded debt favorites have also been trading somewhat lower, and I still believe that the superior returns are to be obtained through debt, not equity investments, at least with smaller issues. I’m still not confident that over-leveraged companies will be able to deliver returns to shareholders in this environment.

One of my favorites, Harvest Energy Debt (not equity!), is trading around 68 cents, which would give it a yield to maturity of 20.7%. I highly suspect that an investment in the equity would return less than this – they had a secondary offering where they raised $115 million, but this will be hugely dilutive to equity holders. I suspect issues like these will drop in price as crude drops. If we see a 20% price compression or so in those debt issues, I would take it as a good time to continue loading up.

True Energy Trust has a bond issue that trades at 70 cents on the dollar, which looks tempting – yield to maturity of 28%. It has a short maturity (June 2011), and the risk is that their credit facility will not get renewed. Given the awful first quarter they had (which crude selling at an average of US$43/barrel), it only gets better for them, which means it is likely they will be able to renew their facility and refinance their debt. The equity holders will lose in this transaction.

With all of these debt issues trading at rather high yields (Sprint is still at 14.4% for a 19 year maturity), it is very difficult to justify the risk of equity at this moment. Equity prices are still far too high for my liking. The place to be, for the moment, continues to be the corporate debt market. They will not be immune to price shocks, but investors will be well compensated for this risk. They also have the advantage of having a maturity date.

This entry was posted on Tuesday, July 7th, 2009 and is filed under Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.