I wrote back on 18th December in Corporate Bonds: Discounting Depression that investment grade corporate bonds were a cheaper and lower risk play than equities on eventual economic recovery and a a natural home for investors seeking yield in a ZIRP world. On that very day AAA spreads peaked at over 3.5%, and have since fallen sharply to 2.88%. The chart below indicates just how historically extreme the risk premium on AAA rated bonds over 30 year Treasuries has become. I would expect spreads to tighten further to no more than 200bp over the year. Of course, that spread retracement is of little comfort if the Treasury market itself implodes, and bubble talk is now commonplace, but near-term probably misplaced. Risk aversion will remain elevated this year, and Treasuries are not a bubble in the sense of Dotcom stocks or Miami condos because investors have driven yields to historic lows not in anticipation of capital gains, but in sheer terror of capital loss.

Although foreign central bank demand will diminish, the dramatic rise in private US saving will help absorb some of the new supply, as will newly conservative banks seeking to shore up their balance sheets (remember back in the 1950's it was common for local US banks to have 70-80% of their deposit base invested in bonds). Nonetheless, I would avoid government bonds on valuation grounds and prefer corporates and TIPS (where you get the inflation hedge for free). I think very late 2009 or even 2010 is more likely to see a secular top in the government bond market, as the medium-term deflation scenario starts to recede and bond supply becomes overwhelming. On that view, a steadily rising risk and yield appetite should be reflected in AAA corporate bonds before other markets like equities and commodities, and is a good each-way bet in what will be another volatile year for markets.