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Author: solasis Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 297  
Subject: bond spreads - corporate debt risk premium Date: 10/26/2001 4:42 PM
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the spread between high grade corporate bonds (A and above) and the 10 year US treasury has widened in the past month to levels seen only a few times since 1945.

recent cycles (weekly data rounded to the nearest 10BP; 100 BP=1%)
cycle low - cycle high
1970 60 1971 220
1973 70 1974 240
1978 50 1980 220
1981 70 1982 340
1984 90 1986 250
1989 80 1992 200
1994 80 1998 240
2000 140 2001 340?

after hitting nearly 350 Basis points a few weeks back spreads have closed back to the 280-300 range, but historically this is still a very wide spread ( a high risk premium). a chart of the spread in 10 year durations over time can be found at ed yardeni's website

http://www.yardeni.com/public/mktcycle.pdf

This anomalously high spread is particularly interesting because of the dwindling supply of higher grade corporate debt. ford, for example, came public this week with a huge debt offering but it is rated BBB.

tr

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Author: remedialstudent Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 96 of 297
Subject: Re: bond spreads - corporate debt risk premium Date: 10/27/2001 1:02 PM
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The wide and widening spread between treasury and corporate debt yields is something that has interested me ever since LTCM blew up in 1998. As nearly as I can tell, the focus on LTCM's problems (aside from the massive leverage they employed) has been almost entirely on the risk side of the equation. The problems on the risk side have been well documented, but there's been little to no focus on what's been happening on the risk-free side, i.e. the treasury yields which LTCM funded with.

The risk side is easiest. Moody's used to document it weekly (I really miss getting Lonski's reports free from Moody's website). Credit downgrades have outnumbered upgrades dramatically since early '99. My first instinct when I heard this was "So What?", you downgrade the bonds and they go from Aa to Aaa, how does this push the yields of Aa's overall up? But then I figured that the ratings agencies lagged the market -- the market was steadily pushing the yields of these bonds higher (relative to other yields) while Moody's was still calling them Aa.

However when you get the downgrade, this should push both Aa's and Aaa's lower since presumably a bond recently graded Aa should still be a mrginally better credit than one that has been Aaa for years, and Aa would improve from the benefit of no longer having bonds near downgrades included in their ranks. I think this explains some of the increased volatility and the seeming cyclicality in the spread between lower and higher graded corporate debt over the last few years. Yardeni has a more in-depth look at quality spreads that has this info http://yardeni.com/public/qs_c.pdf

But in any case, While historically, Moody's Aaa's are trading at their highest spread to treasuries and Baa's are trading at their highest spreads to treasuries, corporate/corporate spreads have not come close to their 1990 recession highs, or their mid-80's levels. This is consistent with the idea that bonds have been consistently graded down and have tended to make lower ratings appear relatively more secure than previous indexes and higher grades relatively less secure.

But, it does not answer why all grades have increased in yields relative to treasuries though, and we know balance sheets have been in worse shape before. It also doesn't explain why commercial paper yields are at historic lows relative to T-bills. Corporations are a great bet for the next 3 months, but not the next 10-20 years? Maybe, but that's not the way its worked in past recessions. And it doesn't jibe with corporate equity action where all stocks were graded up relative to treasuries (and still are) and blue chip companies were graded up relative to less secure ones. There might be some answers to this inconsistency, but I haven't found them. I'd be glad to hear ideas.

At any rate, these discrepencies got me looking at the risk free side of the equation, treasury debt. It has a story to tell too.

Over the last several years, total treasury debt has held roughly steady, but this masks important changes in the composition of how that debt is held. From 1998 on we've had a budget that was in surplus once social security revenues are tossed into the mix, and by law Social Security is mandated to hold its surplusses in treasury debt. So while total government debt is unchanged to marginally higher, the amount of marketable debt -- debt sold to the pulic -- has declined markedly falling from 1/2 of GDP to 30% of GDP.

But there's been no commensurate decline in the demand for risk free debt. Relative to other types of debt, demand for treasuries is somewhat constant due to pensions and mutual funds manditorily invested in treasury debt, foreign central banks, etc.

This shows up in the stats. For example, as overall foreign purchases of treasuries and foreign central bank holdings of treasuries as a % of non-gold reserves have declined outright (as they must when marketable debt declines), total foreign holdings and foreign central bank holdings of US federal debt as a % of marketable treasury debt have increased. The Federal Reserve has increased its holdings of agency debt as treasuries have become more scarce, but has still been a net buyer of treasury debt increasing its holdings as a % of marketable debt.

So my hypothesis is that since there is no longer a steady $100-150 billion supply of t-bonds coming to market annually, these relativeley price insensitive buyers and holders of treasury debt have been forced to bid the price of treasuries up in order to purchase the marginal bond from other investors. The problem becomes more pronounced when there's an event like Sept. 11 or the Russian default in 1998 and there's a surge in investor demand for risk free treasuries. The Treasury recently held emergency auctions, not because it needed the cash, but because bond dealers couldn't cover their sales of treasuries.

It's also worth noting that the big bond trading firms aren't doing it anymore. Saloman Bros. closed their arb shop in 1998, so did Goldman Sachs. These firms traditionally were shorters of treasuries, and with the lack of supply out there they would have had a difficult time the last couple of years, but here is another plausible sign of budding in-efficiencies in this spread. As treasuries become more plentiful, which I can't help but think they will since the social security surplus is really a proxy for future borrowing rather than a sustainable surplus, long corporate/short treasury debt might become a lucrative trade. After all, Saloman and Goldman didn't leave the business because it wasn't profitable, but because bond trading made earnings unstable for Saloman's parent Citi, and Goldman's IPO.

But then again, maybe this explains the widening spreads in long term corporate/treasury bonds relative to short term spreads. If Social Security is in big surplus now but won't be ten years from now, why wouldn't corporate pensions be in the same boat?

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Author: solasis Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 98 of 297
Subject: Re: bond spreads - corporate debt risk premium Date: 10/28/2001 5:38 PM
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"But then I figured that the ratings agencies lagged the market "

i can't back this up with stats, but watching the debt market the past two recessions i would tend to agree - the market leads the agencies. in effect "credit watch" basically means prepare for a downgrade.


"It also doesn't explain why commercial paper yields are at historic lows relative to T-bills. Corporations are a great bet for the next 3 months, but not the next 10-20 years? Maybe, but that's not the way its worked in past recessions. And it doesn't jibe with corporate equity action where all stocks were graded up relative to treasuries (and still are) and blue chip companies were graded up relative to less secure ones. There might be some answers to this inconsistency, but I haven't found them. I'd be glad to hear ideas."

liquidity premium? i don't have the answer either - but i think it is important to point out the anomaly.

"If Social Security is in big surplus now but won't be ten years from now, why wouldn't corporate pensions be in the same boat?"

1. different cash flow dynamics
2. what pension plan? the majority are defined contribution plans now.

tr


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Author: remedialstudent Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 99 of 297
Subject: Re: bond spreads - corporate debt risk premium Date: 10/28/2001 8:15 PM
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"It also doesn't explain why commercial paper yields are at historic lows relative to T-bills. Corporations are a great bet for the next 3 months, but not the next 10-20 years? Maybe, but that's not the way its worked in past recessions. And it doesn't jibe with corporate equity action where all stocks were graded up relative to treasuries (and still are) and blue chip companies were graded up relative to less secure ones. There might be some answers to this inconsistency, but I haven't found them. I'd be glad to hear ideas."rem

"liquidity premium? i don't have the answer either - but i think it is important to point out the anomaly." Solasis

Could be.

Could also be that corporations aren't issuing commercial paper and locking in long term rates (again I miss Lonski's articles from Moody's). I know GMAC, who was famous for funding with short term paper then swapping it, did a $6 billion deal in the bond market instead of the cp market last week.

This is an interesting idea because from a supply/demand standpoint it would make the longer term debt look more risky relative to treasuries(adding more supply to the long end of the curve), while arguably the company is running less risk by not having to roll the paper every 3-12 months. Dunno.

"If Social Security is in big surplus now but won't be ten years from now, why wouldn't corporate pensions be in the same boat?"rem

"1. different cash flow dynamics
2. what pension plan? the majority are defined contribution plans now." Solasis

Good point about defined contribution plans. So if we throw that idea out that still leaves us searching. I see a lot of reasons that the spread may be out of whack due to technical factors (the risk free yield is artificially depressed relative to other returns), and as I look at balance sheets, they're better than 10 years ago when the spread was quite a bit narrower (with higher overall yields). That's my story and I'm sticking to it.:)

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Author: TWA40 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 100 of 297
Subject: Re: bond spreads - corporate debt risk premium Date: 10/29/2001 1:21 PM
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tr,

It seems as if the yield spread is a good indicator of relative risk of default, but it doesn't seem like it's necessarily much of a leading indicator. More of a rear-view mirror indicator. I'm just eyeballing the total number of defaults off a graph at PIMCO, and it's not very good resolution, but the peaks in yield spread conform almost perfectly to peaks in numbers of corporate bond defaults. The absolute numbers (based on # of issuers) don't look so good in 2000-2001, but in terms of monetary value, there's a much better correspondance (about $35 B in 2000, $75 B and counting in 2001).

The article this came from doesn't think corporate debt is all that attractive right now. It would be nice if the graph included the total amount of corporate debt over the last 30 years so you could decide if the "bubble" is really as large as it looks, or if it would just look like a molehill expressed in per capita terms on a log scale.

Yield Approx #
Year Spread Defaults

1970 60
1971 220
1973 70 3
1974 240 5
1978 50 5
1980 220 5
1981 70 3
1982 340 15
1984 90 12
1986 250 25
1989 80 25
1992 200 60
1994 80 15
1998 240 30
2000 140 110
2001 340 120+

http://www.pimcofunds.com/PIMCO?op=www&mainsection=bond_center&subsection=commentary&request=investment_outlook&content_id=35267

Todd

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Author: solasis Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 104 of 297
Subject: Re: bond spreads - corporate debt risk premium Date: 10/29/2001 5:16 PM
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todd, the spread i am talking about is between the higher rated debt and the US treasury. aren't all of those defaults in the lower grades BBB- and below? no question there was a lot of high yield debt floated again in the mid to late 90s - look at GX at 20 cents for example.

here again, i'm not sure that the relationship with time holds due to the changing nature of the high yield market since the mid 80's. i can still find secured debt with graham's 4-7 times interest rate coverage yielding 250BP more than a US treasury.

tr

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Author: remedialstudent Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 107 of 297
Subject: Re: bond spreads - corporate debt risk premium Date: 11/6/2001 3:35 PM
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Last week is an extreme example of what I was talking about in this thread. In response to the treasury ending thirty year bond issuance we had the long bond dropping 50 bps in yield while Moddy's Aaa's dropped less than 1/2 that amount, an increase of 25 bps in the spread that had nothing to do with increasing risk. My guess is this is about the top for the spread.

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