On March 24th, swap spreads on 7-year and 10-year treasuries and their equivalent corporate bonds turned negative for the first time ever. With this move, the market signaled that it thinks that U.S. corporate debt is less risky than U.S. government debt. If so, they will have to rewrite the finance textbooks.
A great deal of financial analysis is based on the risk free rate of return. Risk free in this instance means that default is not possible. This rate is the interest rate on government debt. Technically, sovereign governments cannot default on their bonds because they can simply print the money to pay them off if necessary. This of course devalues the currency, creates inflation and thereby raises interest rates, which are other forms of risk. Corporations should always have higher interest rates than the country they operate in as long as the country is a sovereign nation and not part of a currency union such as the euro. This is the case because unlike government, corporations can't print money so they can go out of business and their bonds can default. The higher interest rates on corporate debt are needed to compensate for possible bankruptcy. The opposite situation makes no sense whatsoever and indicates that some very odd things are going on in the markets. Nevertheless, more than one market observer noted wryly that the fiscal soundness of many U.S. corporations is actually much better than that of the U.S. government.
The U.S. had a series of government bond auctions last week and they did not go well. Purchases by both indirect bidders, which includes central banks, and direct bidders, which includes domestic money managers, were both down. In the case of the 7-year for instance, indirect bidders bought 42% instead of the usual 50%. Direct bidders bought 8% as opposed to their average 11% purchase. When fewer bonds are bought at auction, primary dealers get stuck with the unsold inventory and then they usually dump it on the market. Bonds then sell off and interest rates go up. The yield on the 10-year rose 15 basis points last Wednesday and peaked at 3.94% on the week, almost as high as last June. Interest rates on treasuries of other maturities rose across the board.
Investors should pay particular attention to the lower demand from central banks and wonder if a lack of purchasing by China is behind this. There is an ongoing struggle between the U.S and China on whether or not China is keeping the yuan dollar exchange rate artificially low. There will be a ruling by the Treasury Department on April 15th on whether or not China is a currency manipulator. Needless to say, the Chinese are not particularly happy about this. China was a net seller of U.S. government bonds in December and January. A significant drop in their buying would cause U.S. interest rates to go up considerably.
Investors should keep an eye on treasury interest rates. The 10-year and 30-year rates have been on the decline since 1980. They now look like they are reversing this pattern and are poised to begin a multi-decade rise in interest rates (and lower bond prices). Shorting treasuries is the way to take advantage of this sea change. Two ETFs, TBT and TMV offer leveraged plays on long-term treasuries (twenty to thirty years) for those who think interest rates are going to rise.
Disclosure: None
NEXT: Questionable Oil Statistics More Accurate than Other Government Numbers
Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21
This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.
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