The Bond Market Is Back to Almost Normal

06/29/2009 11:00 am EST

Focus: BONDS

David Wyss

Adjunct Professor, Brown University

David Wyss, chief economist for Standard & Poor’s says bond spreads have narrowed as the financial panic subsides, but things haven’t returned to normal yet.
We expect the US economy to begin to recover late this year—but at a sluggish pace. We do not expect to see positive gross domestic product (GDP) growth until the fourth quarter.

Financial markets are calming down. Credit spreads are down to their lowest levels since before the Lehman Brothers failure, and credit default swaps are trading at lower prices. Markets are certainly not back to normal, and they’re even further from their abnormally complacent levels of two years ago, but they have improved.

The spread between speculative-grade security yields and yields on US Treasuries narrowed to 10.9 percentage points at the end of May, down from a peak of 17.5 percentage points in December. Two years ago, the spread was a record low 2.6 percentage points compared with a 15-year average of 5.2. The spread index for investment-grade securities narrowed to 3.5 percentage points, down from a peak of 5.8 but still well above the historical average of 1.9.

Some of the narrowing of spreads can be traced to the Federal Reserve’s programs. The Term Asset Lending Facility (TALF), along with purchases of agency and Treasury debt, helped moderate the spreads. In most cases, the Fed has not had to buy many of the securities; just the knowledge that the facility is available has been enough to assuage liquidity fears and encourage the private market to buy them.

The rise in Treasury yields is to some extent a reflection of the narrower spreads. When the ten-year Treasury yield fell to 2.1% last winter, it was in part because of panic buying. The panic is subsiding now, and over the last six months, the ten-year Treasury rose to 3.7% from 2.1%. A steeper yield curve is a positive sign for the economy in the index of leading economic indicators.

Even at a 3.5-percentage-point spread over the 2.5% five-year Treasury yield, the average investment-grade company can get money at 6%, a very low rate by historical standards. Speculative-grade companies are borrowing at 13.4%, still pretty expensive, especially in a zero-inflation environment, but not totally prohibitive for the higher-rated (BB) speculative-grade firms.

But there is probably also an element of fear in the rise in Treasury yields. The federal government is expected to borrow about $2.5 trillion on net this year, with the deficit reaching 13% of GDP. Markets are beginning to worry about how long that level of borrowing can be sustained, especially if foreign buyers are averse to US bonds. We expect the ten-year Treasury yield to rise to 4.2% by late this year and 5% by the end of 2010.

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