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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

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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