Published: October 22, 2007
NEW YORK: The combination of record U.S. home foreclosures, rising defaults and simmering inflation is making two-year Treasury notes and their equivalents unbeatable in the bond market.
Anxiety over the $300 billion owed by structured investment vehicles, or SIVs, is pushing investors into the relative safety of two-year notes sold by the U.S. government and the most creditworthy companies, at the same time that rising consumer prices reduce the appeal of 10-year securities. The gap in yields between the bonds is getting wider, reminiscent of 2001, when the Federal Reserve began cutting its target interest rate for overnight loans between banks.
Barclays Capital, UBS Securities and strategists at other firms that trade directly with the central bank said the so-called yield curve represented by the gap between yields on two- and 10-year government notes would get steeper as the U.S. economy slowed and pressed policy makers to cut borrowing costs a second time this year. UBS says the spread may widen to 2.50 percentage points from the current 0.61 percentage point within two years.
"Across 2008, sustained steepening of the yield curve will be a consistent theme," said Ajay Rajadhyaksha, co-head of fixed-income strategy in New York at Barclays.
Buying two-year notes has been the best strategy for investors since yields reached their low points of the year on Sept. 10. Government debt maturing in 2009 returned 0.28 percent over that time, compared with a loss of 0.94 percent for 10-year Treasuries, according to data compiled by Merrill Lynch.
About the only fixed-income investments that have performed better are shorter-maturity securities sold by companies with the least chance of defaulting and government-sponsored agencies, according to the Merrill data. While tracking Treasury notes, they also offer higher yields.
Corporate bonds with top triple-A credit ratings due in one to three years have returned 0.44 percent since Sept. 10, Merrill data show. General Electric's $250 million worth of 8.3 percent notes due in 2009 have gained 0.52 percent, according to data compiled by Bloomberg.
The so-called agency bonds of the mortgage finance providers Fannie Mae and Freddie Mac have also returned 0.52 percent.
Investors seeking safety bought short-term securities last week after Rhinebridge, the structured investment vehicle run by IKB Deutsche Industriebank, said that it might not be able to repay all its debt, and receivers said that a fund run by Cheyne Capital Management of London would stop paying creditors. Structured investment vehicles borrow in short-term markets to finance purchases of longer-maturity assets.
The yield on the benchmark two-year U.S. note tumbled by the most since September 2001 last week, by 45 basis points to 3.78 percent. The 10-year yield dropped 29 basis points to 4.39 percent. As recently as June, the yields were even at about 5 percent.
There is a "sentiment game" that is causing yields to diverge, said Jamie Jackson, who oversees government debt trading at RiverSource Investments in Minneapolis. "People are frightened. They're pricing in a higher probability of Fed rate cuts and that's rallying the front end of the curve."
Mortgages entering foreclosure increased to 0.65 percent in the second quarter, the highest level recorded in the 35 years the Mortgage Bankers Association has tracked the data.
U.S. home builders broke ground at an annual rate of 1.191 million homes in September, the lowest pace in 14 years, the Commerce Department said last week. The same day, the government said consumer prices rose 2.8 percent last month from a year earlier, matching the biggest increase of 2007.
