Are investment grade corporate bonds the new “safe-haven” for investors?

You certainly wouldn’t think so following their worst monthly drubbing since 1980 in October. September and October sliced and diced investment grade debt to levels unseen in more than two decades with effective yields now at 8% compared to 3.7% for ten-year U.S. T-bonds.

Short-term Treasury bonds have been a magnet since the onset of the credit crisis drawing safe-haven flows from nervous investors worldwide ahead of redemptions, fund closures and panic selling since mid-September when Lehman Brothers failed. At the same time, investment grade debt has been smashed. The spread, or difference, between the Dow Jones Corporate Bond Index compared to ten-year Treasury bonds is 431 basis points; prior to the subprime blowup in August 2007 that spread was under 80 basis points.

But do corporate bonds really deserve this discount, even in the midst of asset deflation?

Judging by several poor auctions last week of government bonds, including a failure in Germany of a benchmark ten-year issue, investors might want to look at intermediate and short-term investment grade corporate bonds instead. Though companies can’t print money like governments, the majority of these AA and A credits harbor far superior balance sheets than global governments in late 2008.

Through September 30, U.S. companies held $675 billion in cash – the highest level in more than 15 years.
In many ways, U.S. companies are better credits than government agencies, states and municipalities. Large cap companies in the S&P 500 Index have already refinanced or financed new loans prior to August 2007 when rates were near record lows and, in most cases, don’t have high debt-to-equity ratios like financial companies and the Federal government.

Kraft Foods, for example, funds most of its ongoing debt commitments organically through revenues, unlike the government, states and municipalities. Personally, I’d much rather own credits issued by Kraft Foods, Nestle, General Mills, McDonald’s or YUM Brands.

Even financial company debt, like American Express and J.P. Morgan Chase remains highly attractive because of government backstops initiated in October to guarantee interest payments. If that’s the case, why would someone buy a U.S. T-bond paying 3.7% compared to 7% for an American Express bond when the latter’s promise to repay is now fully guaranteed by the U.S. government?

In Europe, a slew of governments will increasingly have trouble raising fresh capital as auctions saturate the market. It’s the same in the United States whereby weekly auctions will accelerate next year to fund the explosive cost of TARP and other bailouts as the economy continues to deteriorate. At some point, the world will tire of Treasury debt, especially long-term T-bonds, and, ultimately, the dollar. That’s when I expect Treasury yields to start climbing.

Meanwhile, deflation remains mired across the industrialized world this fall. Declining asset prices are causing all sorts of dislocations for governments, companies, individuals and especially those seeking to refinance debt. Credit is indeed hard to obtain.

Treasuries will remain well bid for now. But I suspect a big bear market to unfold for Treasury debt once this panic ends.