The Federal Reserve's actions at the end of the first quarter to shore up liquidity for broker-dealers alleviated investors' fears of a systemic financial collapse and spawned a relief rally in the markets for riskier types of debt.
Then, as the quarter was drawing to a close last week, investors again pulled out of risky assets amid the possibility of more big losses at investment banks, concerns about the solvency of bond insurers and worry about the economy's ability to withstand high oil and food prices.
Investors also were nervous about the ability of bond insurers MBIA Inc. and Ambac Financial Group Inc. to meet obligations under their contracts after credit-rating firms slashed their ratings. MBIA and Ambac together guarantee more than $1 trillion in debt.
As the stock market weakened to lows for the year and oil prices reached highs, the cost of protection against default by companies like General Motors Corp. and Ford Motor Co. rose, because of the impact of high fuel costs.
Inflation became the dominant force in fixed-income markets in June as the Fed turned its attention to the effects of high oil prices and the weak U.S. dollar, amid stronger-than-expected economic growth. "The big risk to credit is that inflation spins out of control," says Ajay Rajadhyaksha, head of U.S. fixed-income strategy at Barclays Capital.
Before last Thursday, when investors sought safety in government debt, the sharpest and most unexpected move in the credit markets in the quarter was a fast and furious selloff in Treasury bonds in early June, particularly in the two-year note as a move into riskier assets that was already under way picked up speed.
As Treasury prices fell, the yield on the two-year note shot up to 3% from 2.4% in a matter of days, blindsiding investors who bet that the yield curve would continue to steepen. Instead, the difference between yields on two-year Treasury notes and the 30-year Treasury bond fell to 1.70 percentage points from 2.23 percentage points in the week ended June 12. That difference is currently 1.9 percentage points.
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The two-year note ended the quarter yielding 2.63%, after starting out at 1.6%, even after the Fed cut its benchmark short-term rate at the end of April to 2% from 2.25%, its seventh cut since September. The Fed kept rates at 2% at its June 25 meeting, amid speculation that it would consider an interest-rate increase to curb inflation at its next meeting in late August.
Many investors were surprised that the Fed wouldn't try to engineer a steeper yield curve, cutting short-term rates to aid financial institutions. In particular, small and regional banks face more turmoil in the second half of the year as home prices keep falling and their loan portfolios deteriorate. Banks profit from borrowing at low rates in the short term and lending for longer periods at higher rates.
The 10-year note's yield rose to 3.97% in the quarter, from 3.4% at the start, and the 30-year Treasury bond's yield rose to 4.5% from 4.3% at the end of March.
Financial institutions' woes registered most acutely in the stock market. Share prices of big firms like Lehman Brothers Holdings Inc., Morgan Stanley and Citigroup Inc. slumped amid announcements of more write-downs tied to bond insurers' woes, and illiquid and mortgage-related assets, but their bonds remained relatively stable and the cost of protection against default remained in check.
The annual cost to buy protection for five years against the default of $10 million of Lehman Brothers' debt rose to $300,000 by mid-June but fell back to $280,000 by the end of the quarter, according to data provider Phoenix Partners Group -- still well off its highs of more than $400,000 in March. Meanwhile, Lehman's share price fell 47% in the quarter.
With the Federal Reserve's emergency borrowing window in place for troubled securities dealers, investors concluded that banks' efforts to cut back on the use of borrowed money for investing, and their moves to raise capital were positive for bondholders. Stronger balance sheets offer more security to bondholders that they will collect on their debt.
Indeed, there were signs of strength in the quarter. May set a record for new investment-grade bond issues, according to Thomson Reuters, as companies raised some $141.4 billion of cash in 134 deals. In the quarter, investment-grade companies issued $309.4 billion of bonds.
Prices of junk bonds and leveraged loans rose in the quarter and companies with weak credit ratings crept back into the market to issue new bonds after months of nearly no new deals.
Junk-bond spreads, or the difference between the yield on junk bonds and risk-free Treasurys, fell more than a percentage point in the quarter, to 6.4 percentage points from 8.2 at the end of March, according to Merrill Lynch, but they widened back out to 7.4 as of Friday. Investment-grade spreads fell to 2.68 percentage points from three at March's end.
The market absorbed a mix of deals to refinance existing obligations as well as bonds and loans to finance mergers and acquisitions in this quarter, says Andy O'Brien, co-head of leveraged finance at J.P. Morgan Chase & Co. Just last week, junk-rated company Intelsat sold $7.1 billion of bonds to pay down bridge loans set in place last year to finance its 2007 acquisition by a private-equity firm.
Verizon Communications Inc.'s announcement that it would buy wireless carrier Alltel Corp. for $28.1 billion, including the assumption of $22.2 billion in debt, just seven months after the company was acquired by private-equity shops TPG Capital and a unit of Goldman Sachs Group Inc., was considered a signal that the merger markets are deftly sorting through the mess from the credit crunch.
The overhang of unsold loans and bonds connected to 2007's leveraged-buyout boom has shrunk to about $64 billion from $237 billion last August, according to Standard & Poor's Leveraged Commentary & Data.
Write to Liz Rappaport at liz.rappaport@wsj.com
