But many other analysts think the market may be close to bottoming, and they are recommending a return to high-grade debt.

Zane Brown, a fixed-income analyst at Lord Abbett, sees clear dysfunction in the bond market as evidence that fear has trumped fundamentals.  He points to the irrationally small and even negative yields on short-term Treasuries.  During major periods of turmoil, he would anticipate high-grade corporate spreads to move from around 80 bps to 130 bps, not 400, 500, or 600 bps.

Although he believes government commitments will successfully address the crisis, he sees capital markets still questioning the ultimate efficacy of intervention.  “My only real concern is if both institutional and retail investors ignore new government initiatives and convince themselves that a Great Depression-like market is inevitable,” says Brown.

He sees the economy coming out of recession by second quarter 2009 and bonds gradually improving over the following year.  That is why he sees a rare opportunity in today’s yields.  Brown is recommending high-grade 10-year maturities because of their extensive offerings and liquidity.  (Because the yield curve is relatively flat beyond 10 years, investors wouldn’t get significantly compensated for the additional risk and volatility of longer maturities.)  The combination of high yields and capital appreciation (if yields contract) could generate double-digit annualized total returns, posits Brown.

Looking towards Europe, Neil McLeish, European credit strategist at Morgan Stanley, is also optimistic:  “We are upgrading to an outright bullish stance on European credit markets for the first time since the start of the current bear market.”  He’s more enthusiastic about bonds than he has been since the bottom of the last bear market in October 2002. 

In terms of pricing, McLeish says “valuation is now extreme even on a 100-year view, sentiment reflects outright panic and an underlying sense of exhaustion and disbelief, and fundamentals for higher-quality credit are now improving (but ignored), in our view.”   Specifically, he’s overweight investment-grade debt, especially in the largest European banks and non-cyclical corporates.

Tim Bond, head of global asset allocation at Barclays Capital, has shifted his previous zero fixed-income exposure to a 25% weighting in bank debt, and he has even established a 10% weighting in subprime, indicating that some bold money is betting that the most toxic layer of the fixed income markets may be underpriced.

Caveat Emptor

There is little doubt that fear is playing a big role in the collapse of securities markets.  What’s more, the scale of government intervention is huge and unprecedented.  Still, we are venturing into unknown territory, which means there can be no assurance of how things will play out. 

The severity of the crisis has taken our eyes away from what is traditionally the essential concern for bond valuations and returns: inflation.  The government’s bailout and rescue actions will likely fuel rising prices, even though the precipitous collapse of commodity prices and a strengthening dollar have helped relieve near-term inflationary pressure.
 
One would be hard pressed to find an economist who isn’t deeply concerned about the sudden infusion of billions of dollars into the banks, coordinated multi-market interest rate cuts, inevitable fiscal stimulus packages, and what all of the above will mean for consumer prices and interest rates.

Even when the financial infrastructure isn’t under siege, it’s virtually impossible for governments not to overshoot in promoting growth and avoid generating inflation.  If inflation approaches double–digit levels, today’s enticing bond prices may not prove to have been cheap enough.

So what then should be done?

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