By Daniel Kruger and Dakin Campbell
March 16 (Bloomberg) -- Even in the world’s safest debt market, investors are paying triple the average premium for the easiest-to-sell securities as the 19-month credit-market freeze shows few signs of ending.
Buyers requiring only the newest, most-traded 10-year Treasuries are giving up about 0.4 percentage point of yield compared with older debt of similar maturity, according to Barclays Capital Inc., one of 16 primary dealers required to bid at government debt sales. Before the subprime mortgage crisis began in August 2007, the gap was about 0.13 percentage point.
Treasuries already lost 2.85 percent this year, according to Merrill Lynch & Co. index data, as the government accelerated bond sales to finance a federal budget deficit that President Barack Obama’s administration forecasts may expand to $1.75 trillion. Sacrificing returns for so-called benchmark bonds shows how skittish investors remain as financial markets deteriorate in the worst crisis since the Great Depression.
“It’s a pretty telling sign that things are not back to normal,” said Wan-Chong Kung, who helps manage $76 billion in fixed income at FAF Advisors in Minneapolis, the asset- management arm of U.S. Bancorp.
For investors who don’t need benchmark Treasuries, the older off-the-run securities, as they’re known to traders, are bargains, according to Kung.
‘Let Them Work’
The 8.875 percent 30-year bond that the government sold in February 1989 yields 0.4 percentage point, or 40 basis points, more than the current 10-year2.75 percent note, which is the most comparable security and yields 2.89 percent, according to data compiled by Bloomberg. That amounts to about $40,000 a year in interest on a $10 million investment.
“I don’t expect instant gratification,” said Kung. “I set these high coupon guys on the side and let them work over time.”
Since July 2006, the yield gap, or spread, between benchmark and off-the-run 10-year securities has averaged 23 basis points, according to data compiled by the unit of London- based Barclays Plc. The average since September, when the seizure in credit markets intensified following the bankruptcy of Lehman Brothers Holdings Inc., is 46 basis points.
“It definitely represents value,” said Steve Rodosky, the head of Treasury and derivatives trading at Newport Beach, California-based Pacific Investment Management Co., which runs the world’s largest bond fund. “What you’re surrendering and what it’s a reflection of is market liquidity.”
Offers Refused
Once a new benchmark security is issued, older securities tend to trade less often, as seen in the difference between what traders are willing to pay for the bonds and the price at which holders will sell. The so-called bid-ask spread for the current 10-year note ended last week at 31.25 cents per $1,000 face amount, compared with 62.5 cents for the 8.875 percent bond, according to BGCantor Market Data.
Fifth Third Asset Management Chief Investment Officer Mitchell Stapley ran into a lack of buyers in December when he tried to sell off-the-run Treasuries that were trading in the 120s, or about $200 above their $1,000 face amount.
Dealers “just didn’t want to commit capital,” he said. “They were making me an offer I could easily refuse. We shouldn’t have to work this hard to sell an off-the-run Treasury. That should always remain one of those liquid portions of the market.”
JPMorgan Chase & Co. recommends buying off-the-run securities, betting that the difference in yields will narrow. Older securities “have remained persistently cheap,” JPMorgan strategists Srini Ramaswamy and Kimberly Harano in New York said in a March 9 research report.
Switching Focus
While the premium for benchmarks has increased from before the credit markets seized up, it’s down from 63 basis points in December, when investors drove U.S. government debt yields to record lows amid mounting losses in equity and credit markets.
Since the start of the year, investors have focused on the rise in Treasury sales as the Obama administration raises funds to pay for the $11.7 trillion bailout of the banking system, as estimated by Bloomberg calculations, and the $787 billion economic rescue package. The economy may contract 1.8 percent this year, after expanding 1.1 percent in 2008, according to a Bloomberg survey of 65 economists.
New York-based Goldman Sachs Group Inc., another primary dealer, estimates the U.S. will almost triple sales this year to a record $2.5 trillion.
Increasing Demand
Demand for the most liquid Treasuries is increasing as the plunge in financial markets worsens. While the Federal Reserve is pouring money into the banking system, the Standard & Poor’s 500 Index has lost 16 percent this year and corporate bonds are down 2.31 percent, Merrill indexes show.
At the same time, central bankers and Treasury haven’t been able to meet Fed Chairman Ben S. Bernanke’s goal of reducing consumer interest rates along with the borrowing costs paid by banks. The difference between rates on 30-year fixed mortgages and 10-year Treasuries was 2.15 percentage points on March 13, according to data compiled by Bloomberg. That’s up from an average of 1.75 percentage points in the decade before the subprime mortgage market collapsed.
“We still have an economy that’s deteriorating,” said David Coard, head of fixed-income trading in New York at Williams Capital Group, a brokerage for institutional investors.
Short-term borrowing costs are rising for financial institutions as they hoard cash following $1.24 trillion of writedowns and losses since the start of 2007.
High Rates
The London interbank offered rate, or Libor, that banks say they charge each other for three-month loans, crept to 1.33 percent last week from this year’s low of 1.08 percent on Jan. 14, the British Bankers’ Association in London said. The premium they charge each other for short-term loans as measured by the so-called Libor-OIS spread has remained above 1 percentage point since Feb. 19 after holding below that threshold in the prior five weeks.
The economy’s contraction has led to a reduction in the number of companies awarded the safest credit ratings. General Electric Co., based in Stamford, Connecticut, and Warren Buffett’s Berkshire Hathaway Inc. in Omaha, Nebraska, lost AAA grades last week. Five non-financial U.S. companies, including Microsoft Corp. of Redmond, Washington, now hold S&P’s AAA grade, down from more than 60 in 1982, the ratings firm said.
The extra yield investors demand to own below-investment grade debt as measured by Merrill is rising at the fastest pace since November on concern the longest recession since at least 1982 will push defaults to a record. Moody’s Investors Service expects the nonpayment rate to rise to 14.8 percent by year-end.
‘Little Wary’
“We’ve regressed a little bit here this month,” said Robert Millikan, who manages $5 billion as director of fixed income at BB&T Asset Management Inc. in Raleigh, North Carolina. “You’re still a little wary of everything.”
Primary dealers have reduced holdings of non-Treasury debt securities to $218.2 billion, within $7 billion of the lowest amount since March 2005, according to Fed data. At the same time, the amount of long-term Treasuries the firms held increased to $4.4 billion, approaching the record $15.7 billion in 1998.
All that means that investors will continue to pay premium for the securities they can sell whenever they need cash, said Thomas Sowanick, who manages $20 billion as chief investment officer of Princeton, New Jersey-based Clearbrook Financial LLC.
“Part of it is deleveraging and part is that Wall Street is still wounded,” he said.
