Monday, November 03, 2008

Musings Regarding the Explosion of Treasury Debt and the Implications for Corporate Bonds

A recent article notes that the flood of issuance in the next year is likely to lead to higher yields for Treasury investors. With swelling borrowing needs in the U.S., a need to keep short-term rates low to stimulate the economy, and emerging economies (that had been aggressive Treasury buyers) contracting, a supply/demand imbalance could lead to significant further steepening of the Treasury yield curve. As short-term Treasury bill rates (3, 6 month) have moved significantly below 1%, the 10-year rate has stayed close to 4%--a notable sign of steepening.

Observe, too, that the inflation expectations built into TIPS are quite low, something on the order of less than 1% annually for the next decade. This is leading some investors to move into TIPS as an inflation hedge. What, however, if TIPS pricing is efficient and we are facing a prolonged period of low inflation, if not deflation? With rising Treasury yields at the long end and modest inflation, real returns on these government-backed securities would be quite attractive. This could have the effect of crowding out investment in corporate debt, particularly during a regime of risk aversion. In short, these immense Treasury funding needs that we're reading about may keep corporate (and municipal) bond prices unusually low for an extended period. That has real implications for the funding of the private sector and its ability to rebound from recession.

On a related note, I'm not wild about how bonds have behaved during the last week of vigorous bounce in the stock market. According to FINRA data, we saw an explosion of 52-week price lows among investment grade and high yield bonds in mid-October--the same pattern we saw among stocks. Specifically, we saw 1218 new 52-week lows among the 3432 issues traded within the FINRA-Bloomberg Investment Grade Index on October 14th. On October 16th, we hit 422 new 52-week lows among the 1008 issues traded in the FINRA-Bloomberg High Yield Index. With the bounce into the end of October--one that took almost all stocks off their 52-week lows--we still had 404 new annual lows among the investment grade bonds and 147 among high yield issues. Advance-decline numbers were especially tepid for the investment grade bonds.

A few days does not a trend make, but this relative underperformance is on my radar: even apart from the issue of looming defaults, corporate bonds may fail to keep pace with other assets, including during periods of relative risk appetite. As an increasing number of risk-free Treasuries come to market and compete for relatively scarce investment funds, the competition for yield may pose ongoing challenges for the issuance and pricing of investment grade and high yield bonds. And that is not conducive to a growing economy.
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1 comment:

John Forman said...

Brett,

Your comments on corporate rates and such are all quite logical. The problems is the so-called "Crowding Out Theory" has never actually worked in practice. As one of my colleagues has said, the fact that the government is borrowing more is because either it's spending more or it's taxing less. Either way, that means more capital in the private sector, meaning corporate debt (on aggregate) improves in quality and/or the companies don't need to borrow as much. I'm actually looking at the long-term play being short Treasury debt in anticipation of higher rates, while also looking to be long corporates in expectation of a narrowing of the spreads. But that's just one man's view.

John