The Federal Reserve's second rate cut in a month was aimed at the feeble US economy, not the bond ma...
The Federal Reserve's second rate cut in a month was aimed at the feeble US economy, not the bond market. But you would not know it from the goings on in bondland these days.
Even though Treasury yields have edged higher since the Fed began reducing rates last month, bonds that trade at a spread to government debt are experiencing a revival of sorts. Since its rate cut on 3 January, spreads between the riskiest corporate bonds and Treasuries have narrowed, suggesting investors are more willing to take their chances with lesser credits. The reason is that the Fed is pulling out all the stops to avoid a recession.
The Federal Open Market Committee pumped another generous dose of credit into the financial system on 31 January, lowering its bank rate a half point to 5.5% on top of the 50 basis point cut earlier in the month. The FOMC has not eased credit by 100 basis points in a single month since November 1984, and the symbolism of that aggressiveness has not been lost.
Standard & Poor's index of speculative grade bonds shows that spreads have narrowed to 923 basis points from 1,074 basis points before the Fed's 3 January move.
"What the markets are telling you is that there is more upside to come," says Margaret Patel, Boston-based manager of the Pioneer Strategic Income fund, who expects spreads to continue narrowing.
The healing began in December when data made it clear the Fed would soon lower rates. That hope helped junk bonds in December turn in their best monthly showing in two years.
True, 2000 was the worst year for high yield debt in the last 13, amid slowing economic growth, rising default rates and profit shortfalls among many of the nation's best known companies. But that all changed in December, with junk bonds returning 2.3%. In January junk bonds posted the biggest monthly gain in a decade, nearly 6%.
Since then, corporate issuance has surged. In January alone, junk rated companies raised more than $14 billion, a third of the tally for the whole of 2000. There is plenty more upside for corporate and other spread markets once the economy reacts to the Fed's actions.
"A lower Fed funds rate pushes investors out on the risk curve," says James Cusser, a money manager for Waddell & Reed in Shawnee Mission, Kansas. "So we are seeing money being put into longer maturities and riskier assets," he adds.
The US Government's declining financing needs have been a plus for non-Treasury markets. The Treasury has said it would buy back another $9 billion of debt this quarter and end sales of one-year bills following its 27 February auction. Wall Street executives who advise the Treasury on borrowing decisions raised the issue of eliminating the 30-year bond. The US plans to sell 30-year bonds in August.
Just because Wall Street dealers favour scrapping the long bond does not mean the Treasury will do it. Yet some members of the Bond Market Association's borrowing advisory committee said it would be "illogical" to sell more bonds when forecasts suggest all debt will be erased in a matter of years. The group applied the same rationale in suggesting the US kill its inflation indexed security program.
Treasury officials are taking a more cautious approach. Fed chairman Alan Greenspan has said the growing budget surplus "has reshaped the choices and opportunities before us," allowing debt to be paid off even if Congress cuts taxes.
If the Treasury keeps selling 30-year bonds, there is still little doubt the average maturity of Treasury debt will be shortening in the years ahead. Investors looking to buy debt maturing in 10 years or longer will be forced to widen their horizons beyond Treasuries.
Dwindling government debt levels will make way for private issuers to sell bonds and encourage investors to buy them. That helps explain why investors are again developing an appetite for risk.
Lending further credence to the idea that risk is back in style is anecdotal information on bank credit, according to Ian Shepherdson, chief US economist at High Frequency Economics in Valhalla, New York. That is a source of comfort because recessions are much less likely when credit is flowing, albeit at a slower pace than last year.
It also may be a relief to investors worrying about bond default rates and weakening corporate earnings. "With the Fed taking a 'get serious' approach to adding liquidity to the system, bond investors and consumers will benefit simultaneously," says Mary Dennis, a senior economist at Merrill Lynch in New York.
The Fed has stated its willingness to continue adding credit to the economy, something that may only enhance the attractiveness of investment-grade and high yield securities.
Nowhere in the FOMC's statement did policy makers suggest rates have been reduced enough to boost the economy. The next meeting of the FOMC is on 20 March. Joshua Shapiro, an economist at Schroder Economics in New York, thinks an inter-meeting move before then is possible.
While that is stellar news for the corporate and high yield debt market, Treasuries are not likely to thrive in such an environment.
Dan Antonellis, an economist at Briefing.com in Jackson, Wyoming, says a more accommodating Fed policy will boost the economy and encourage investors to pull money out of bonds and into stocks.
Treasury yields may have edged lower after the Fed's rate move last month, but they are higher than before the Fed began easing on 3 January. The 10-year yield, 4.92% on 2 January, is now at 5.15%.
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