Profiting off the Liquidity Preference

One aspect of this market that I find fascinating is the dramatic yield spreads between short-term Treasury yields (^IRX) and just about everything else. Short-term Treasuries have one major benefit over all other securities and that is their safety. No matter what happens, an investor can be very confident that the U.S. Treasury will pay them back. The Feds, after all, own the printing press.
But what we’re seeing recently is being caused by another advantage of Treasuries and that is their liquidity. The Treasury market is one of the most liquid markets in the world. If need be, Treasuries can be dumped at a moment’s notice for something else. That factor is drawing lots more buyers. The short-term T-bill continues to trade as inches above 0%. Going further out, the 10-year Treasury is now down to 2.8%.
There’s an opposite reaction going on in less-liquid assets. I think this is partly why micro-cap stocks like Nicholas Financial (NICK) are so cheap. There’s an illiquidity discount. In other words, you can’t easily sell when no one is willing to buy. We’re also seeing nearly ridiculous yields for junk bonds.
There are a number of junk bond ETFs. For example, the PowerShares High Yield Corporate Bond (PHB) is yielding 13.8% based on its most-recent monthly dividend payment.
I think we saw a similar “gravitational pull” during the dot.com bubble. When sock puppet companies were going for over 100 times dreams, many high-quality REITs were paying dividends over 12%. The problem was the REITs had kept going down and the dot.coms kept rallying. It seemed as if the breaking point had already passed.
Here’s a look at BAA corporate yields, which still isn’t junk, compared with short-term Treasuries.

One advantage of the liquidity preference would be for the government to issue massive amount of short-term T-bills at their regular auctions. The proceeds could be used to by high-yielding preferred stock is locked-up companies. That way we could use the liquidity premium to the taxpayers’ advantage.
Arnold Kling has more.

Posted by Eddy Elfenbein on December 1st, 2008 at 11:14 am

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