“How can I beat the Lehman Aggregate?” a bond manager friend recently asked me.? Tough question in this environment; I’m still musing about it.? It’s a tough market.

Start with Treasuries — they are the bedrock of the market.

Here is the Treasury yield curve at 4 polar moments in the last two years.? Two times where no one doubted that the economy was bouncing back: 6/10/2009 and 4/5/2010. One time where everyone thought the end was near: 12/18/2008.? Then there is now; the front five years of the curve is like the panic.? 7-20 years is like 75% of the panic.? 30 years is half of the panic, relative to the last two years.

So what to make of it?? Despite the Fed’s willingness to buy twos through tens, I think the thirties look attractive versus twenties and tens.? The curve typically peaks near 20 years, and that’s not true now.

Are things as bad as at the panic point in December 2008?? No, but the front-end thinks so.? I would be inclined to try a barbell where thirties and bills are overweighted, and twos through twenties are underweighted.? How big to make the bet?? That is up to your risk appetite.

Now remember, this is a trade, not a long-term investment.? Sometimes I think that government policy tends to turn us into speculators and traders… the first intentionally, the second by accident.

Now all of this is amid China lightening the boat on Treasuries.? That did not stop the rally.? As the article said:

For one thing, Japanese investors have steadily bought more U.S. debt as China has shrunk its portfolio. Japanese holdings rose to $803.6 billion in June and have increased by $82.7 billion since last July.

Domestic buyers have also helped fill the gap. U.S. household ownership of Treasurys in the first quarter was $795.7 billion, the highest in a decade, according to the latest Federal Reserve data available. Private pension funds, life-insurance companies and commercial banks have also raised their holdings to record or multiyear highs.

China favoring the Euro at this point is an interesting move, contrarian from an investment standpoint, but seeking European favor from a political standpoint.? Politics and economics go together in China, given the crude top-down planning they impose on the economy.

But what kind of market is it when both long Treasury bonds and gold rally at the same time?? It is a fear market that does not know what to fear.? “We fear ‘flation!!!”? Which kind of ‘flation, they are not sure, but things look bad.? Makes me want to short them both, but let the momentum die first…

Agency mortgages are problematic because of the weakness in home prices leading many mortgages to be not refinancable.? Thus the bonds trade at low interest rates, but high spreads to Treasuries.? Personally, I don’t think a mega-refinance is possible legally, but that makes the bonds a little cheap to Treasuries.? This would be an area to analyze collateral, and buy selectively.

One thing that is different from the panic in December 2008 is that corporate spreads are tighter now.? BBB bonds still look attractive, but with junk, you have to be selective.? I would focus on highest quality, and BBBs, and underweight the rest.? Consider buying the bonds of Moody’s.? Quite a spread at 3%, and unless something weird happens, it is still quite a franchise.

Beyond that there are always issue-specific bonds that seem to be undervalued.? Those are worth tossing in, and adusting the rest of the portfolio to adjust duration and credit quality.

Some closing notes:

• Why is Google issuing commercial paper?? Please, tell me.? They have no lack of short-term liquidity.? Are they aiming for financial profits like a hedge fund would?? In some ways they are already– take note that they are doing securities lending to pick up additional yield (see my comment after the article). If this becomes a large part of Google, the P/E multiple on Google should come down, because financial entities arbing credit spreads do not deserve high multiples.? Better Google should pay out the excess cash to policyholders as a special dividend in 2010.
• As an aside, I would add that the financialization of profits in general brings down the P/E multiples of industrial companies.? It looks so easy at the beginning.? Just finance the purchases of your own products through a captive subsidiary, and the extra profits roll in, with a small drop in the P/E.? That’s fine as far as it goes, but it usually doesn’t stop there; the division head of the finance sub seeks new vistas — if he can lend successfully in one area, he can do it in others.? We’ve got the infrastructure; why not use it?? The result at best is a GE or a Textron — two stocks that have gone nowhere over the last 14-15 years.
• Many people in the US are selfish and want to decrease spending on others, but not themselves.? We see that through both of our clueless parties arguing over priorities, and people who want to see the deficit cut, but not in their prized areas.? The logic of shared pain has not yet arrived.? Things haven’t gotten bad enough to drive real spending or tax reform yet.
• Last note: this is a period where people are demanding certain yield, thus bidding up bond prices versus stocks.? It reveals a lack of certainty about the future.? It makes some stocks look attractive — in many cases corporate bond yields are below stock earnings or cash flow yields, and even below dividend yields in some cases.? This article is an example of this phenomenon.? The key question is how long profit margins can remain elevated.? With labor plentiful relative to work, that could be a while, leaving aside risks in the financial system.

So, what should I tell my friend?? Maybe this:

• Duration: emphasize short and long.
• Credit: emphasize highest quality and some BBBs
• Underweight financials with weak liability structures (I.e., the too big to fail banks) for now.
• Mortgages: play carefully, but play.
• If you don’t get a big yield premium for illiquidity, don’t play in illiquid bonds.
• Can you do a little foreign? If so, diversify a little into the developed world fringe currencies outside of the US Dollar, Euro, UK Pound and Yen.

These are tentative conclusions that I would have to work out further — I don’t have my thoughts together on CMBS, Munis, etc.? That’s all for now.