Investors Are More Comfortable With High Grade Corporate Debt Than With Treasuries

Includes: CLY, IEF, LQD, TYD, TYO
by: Jim Delaney

Maybe it was the resignation of Karthik Ramanathan or maybe it was Douglas Elmendorf’s proclamation? Wait, you mean to say you’ve never heard of Karth or Doug before? Well, since it’s a short week I’m going to help you out just this once.

Mr. Ramanathan had run the Treasury’s office of debt management for the last year and under his watchful eye that same institution had issued more than $8TN in debt, almost half of which was new issuance, e.g. $4TN more debt that will have to be serviced and then repaid than when KR started. As for his successor, Ward McCarthy, chief financial economist for Jefferies & Co. said, “There will be a lot of challenges, the biggest one being a political class in Washington that seems to lack the will to address budget deficits that threaten the long term prosperity.”

Mr. Elmendorf is a director of the Congressional Budget Office and he expressed the same sentiments as Mr. McCarthy albeit about a week earlier when he said, “The U.S. budget deficit is on a trajectory that poses ‘significant economic risks’ and will become unsustainable,” going on to say “that the choices needed to address the medium and long-term budget deficit would be ‘larger and more fundamental’ than in the past.”

Whatever it was that caused it, the fixed rate on a 10-year interest rate swap, another one of those evil derivative products developed by Wall St. to ease the burden of the truth seekers, was priced lower than the rate on the 10-year benchmark Treasury upon which its rate is derived by 2.3bps. A quick primer for those not in the know: Interest Rate Swaps or IRS as they are called, are a generic market proxy for corporate borrowing rates. Similar in some respects to the spreads seen in the Credit Default Swap (CDS) market, in this case the IRS rate was on a basket of AAA names whereas the CDS market index I mention in this space is more of a blend of all investment grade credits.

The 2.3bps is equivalent to a little over 2/100ths of a penny so it is not the nominal figure that is scary, but more that it says investors are more comfortable holding the debt of the highest rated U.S. corporations than Uncle Sam’s I.O.U.s. That same AAA IRS rate had risen as high as 78/100th of a penny after LEH went belly-up so if nothing else it shows how much the credit markets have thawed since then.

Now before you go switching your dollars for monopoly money, it might be worth listening to Chris Ahrens, head of U.S. interest-rate strategy at UBS Securities LLC who says that “the inverted risk premium doesn’t suggest that markets are worried about the credit ratings outlook of the U.S. government, but rather, it reflects the continued hefty level of debt issuance by the government.” Phew, I thought for a moment it was something important. I guess we can just disregard Mssrs. Ramanathan and Elmendorf.

Another point made by Mr. Ahrens is worth noting and that is “the huge demand for different types of higher-yielding debt as investors search for better returns in the current low-rate environment.”

The “low-rate environment” of which Mr. Ahrens speaks is being supported by a number of factors not the least of which is Ben Bernanke’s “extremely low”, “extended period” pledge. This could well gain even more purchase should San Francisco Fed president Janet Yellen become vice chairman of the central bank.

For a window into how Janet sees things we need only listen to a recent speech she made where she said, “Some people worry that sustained federal budget deficits and the huge increase in the Federal Reserve’s lending and stimulus programs could eventually lead to high inflation. Others take the opposite view, arguing the economic slack and downward pressure on wages and prices are pushing inflation down. I would put myself squarely in the second camp.”

Janet is not alone in her view, Tony Crescenzi, portfolio manager at PIMCO, thinks rate “volatility will stay low until the employment situation changes. When it does, speculation about when the Fed might raise interest rates will increase boosting market volatility.”

And, when might that be you ask? Tom di Galoma, head of U.S. rates trading at Guggenheim Partners in New York, thinks that it “is nine to 12 months away before they start tightening.”

With consumer prices increasing by just 0.1% in February and 2.1% over the last year, according to recent releases by the Labor Department, Janet and the boys might be on to something. Removing the oft contentious food and energy components, consumer prices increased by just 1.3% in the past 12 months which is the smallest rise in six years.

“Everybody’s talking about inflation, but we’re not seeing anything yet, at least not in any major or consistent way,” was Dyke Messinger’s view. Dyke is the CEO of Power Curbers Inc. in Salisbury, N.C. who also says business is still off some 65% from pre-recession levels and he hasn’t raised prices in three years.

If you want something slightly higher than Dyke’s curbside view, Kenneth Rogoff, an economics professor at Harvard University says, “There is still a lot of unemployment and excess capacity all over the place. In the short term, deflation is much more the risk.”

Additionally, before we get too bothered about a 4% yield on the 10-year UST (it closed at 3.85% on Friday) we should keep in mind that in between BS and LEH the rate on that benchmark got as high as 4.26% (6/13/2008) so as fears of a double dip recede somewhat higher rates could be considered another sign that the market’s health is returning.

The calming of the Hellenic hysteria could also have had something to do with last week’s selloff in Treasuries as the investors seemed to have booked round-trip tickets on their “flight to quality” during the crisis in Crete.

With the all too much anticipated employment numbers being released while the equity markets are closed this Friday and the bond markets in for just half of it, investors will have only 4 days, not the usual five to solve all the world’s problems, or at least put a price on them.

Enjoy the shortened week.