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I am sorry, I am young, but I have always thought…

Bonds 101:

… the more revenue you earn…

… the more profitable your enterprise…

… the less debt you carry…

… the more promising your future growth prospects...

.....the more attractive your enterprise and hence, lower the yield.

Company U:

…. Company U made less money in 2009 than 2008…..

…. Company U is losing more money each year…

… Company U has almost exponential debt accumulation…

… Company U has revised growth estimates below the inflation rate…

Company U does not appear to be an attractive investment and thus, Company U should have to offer higher yield on its bonds.

Unless, Company U is the United States of America, exists in economic la-la land and record budget deficits, growing trade deficits, record national debt (doubling in two years… just hit a new record now… and now… and now…), and downward revised FY 2011 GDP estimates means record low borrowing rates.

click to enlarge images

What is happening? Let me take a guess and let’s return to 2008.

“Wow, you really messed up this time,” says your rich uncle (Sam).

You know you did. You opened an E*Trade account, on margin (30-to-1 no less), and lost a lot of money dicking around with securities (of the mortgage backed variety). It was all over, you were broke, out of business… well, until your sweet, dear uncle (Sam) decided he couldn’t see the future of his family broke and on the street.

“Tell you what I am going to do,” he says, “I’m going to let you borrow as much free money as you possibly can* from me – on one condition.”

“What’s that?” you ask eagerly.

“You can’t lose it again."

Fair enough. You’re going to borrow his money, make it back, pay him back, and it will all be just like it used to be, pre-crash. But what to invest it in?

Lend it out?

No chance, not in 2008, not for car loans, not for houses.

Currencies? Commodities? Real estate?

Way too speculative.

Stocks? Even blue-chip ones?

Sounds attractive, but you really can’t mess up again.

AAA rated bonds?

From Fooled by Randomness:

Perfect

John’s desk engaged principally in an activity called “high-yield” trading, which consisted in acquiring “cheap” bonds that yielded say, 10%, while the borrowing rate for his institution was 5.5%. It netted a 4.5% revenue, also called interest rate differential- which seemed small except that he could leverage himself and multiply such profit by the leverage factor.

I mean, no way, would financial institutions, all of whom have access to the Fed Funds Rate, ever exploit the arbitrage between the rate at which they can borrow, currently at historic lows and 1/18th the rate John borrowed in the book, and pretty much buy every single bond available.

But let’s say they were (for the sake of argument). What would the chart between the Fed Funds rate and the 1 yr T-Bill look like? I’d say there would be a huge divergence when the initial rate was announced and the 1 yr T-Bill. Another sharp divergence in March of 2009 when people weren’t sure if the world was ending, then slow convergence for the rest of the year. Or, something like this:

Sorry, I asked my friend for the target rate and he gave me the actual. I don’t have access to a Bloomberg terminal. I asked him to do it again, he told me: “I actually have to work for a living.” Ahhh, I love being unemployed.

Anyway, beside borrowing money from the Federal government and lending it back to them at a higher rate, who else would you lend it to? McDonald’s? Johnson & Johnson? GE? Every TBTF corporation in the United States of America and the world?

And if I was a company, what would I do? I’d probably be expecting inflation and trying to lock these suckers up as long as possible.

Maybe, just maybe, the Great American Bond Bubble, isn’t caused by a flight to safety as Siegel and Schwartz hypothesize, and is due to excessive capital allocation, you know, kind of like every bubble in the history of mankind. But what do I know, I don't even have access to a Bloomberg terminal.

*The Fed Fund Rate is the rate at which commercial banks can borrow from the Federal Reserve. Since 2008, every major investment bank, Goldman Sachs & Morgan Stanley (through changes in registration), Bank of America, Citigroup, and every other major bank has access. It’s a powerful tool, people believe that low rates of 4% during the Greenspan error is what caused the housing bubble. But hey, what are the odds that rates 1/16th the amount could cause any kind of market distortion?

Disclosure: Expecting inflation