David Merkel submits: There has been a significant shift in bailout psychology over the last week or two.  The grand shift has been to make the cost of receiving money from the U.S .government smaller, which gets “banks” to line up for…

You nailed it.The returns on investment grade corporate debt compared to equities on a risk/reward analysis are very compelling.

I have also been looking at this trade. I wonder if the results you are not being a little skewed by the composition of the HY index.

I think you will find that car companies and their associated finance arms make up a large segment of the index and looking at their current condition have a much higher default probability than the rest of the index as a whole.

This is to say if you could trade a HY index less autos & autos finance it would be a great trade… with those two bits in you are basically taking a massive bet on the default risk of GM and GMAC… Thoughts?

My major concern with your analysis, and that of many sophisticated analysts like Arnott is the focus on spreads as being the major determinant of “value”. The problem with focusing on spreads is the risk that the bogey being used to set the spread is massively overvalued. I could and would argue that long term US treasury yields are WAY too low given the monetary risks facing fixed income investors. Your points regarding Debt to GDP are spot on, but it seems to me that you aren’t connecting the important dots – at least from my perspective. The government will print money at alarming rates to prevent full blown deflation. As Jim Rogers has stated in hyperbolic terms, we could have an “inflation holocaust”. Even Buffet sounded an alarm during his Charlie Rose interview that inflation would be a big problem in a couple of years even as he endorsed the big bailout.

When I think about the amount of printing that is and will likely occur and combine that with the laughable reported CPI figures, I think that anyone buying a 10 or 20 or 30 year treasury is nuts if they intend to hold to maturity. I think it is very easy to envision a 10 year at 6-8% in the coming 3-5 years and corporates yielding 9.5% won’t seem all that attractive at that spread – especially if the inflation emerges despite the potential for a blase US recovery and what that could mean for profits and default rates.

I’ve personally moved some client money into Dan Fuss’s fund, as he has shown an ability to add significant value in analyzing corporate credits as well as currency and sovereign situations. I also added a short in long term treasuries.

So while I agree that there are likely pockets of extreme value in corporates, I’d be interested in reading your thoughts about my criticism about focusing so much on spreads and not considering absolute value of the bogey – i.e. treasuries.

If you want to combine corporates with fairly cheap equity, check out Torchmark (TMK). I don’t own the stock, but they have the vast majority of their investment portfolio in low investment grade corporates. The stock was punished for that, along with the other insurance companies, but might fit your thesis. Not quite the same as direct investment in the debt market, but it’s an idea perhaps worth looking into, given your background. Buffett owns a slice of it, from earlier days, no shocker there.

Steve
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