Not All Yield Curves Are Steepening

The Treasury yield curve has been steepening recently, reflecting bond managers' view that the economy is about to get a lot stronger. However, corporate bond yield curves have been flattening, and that could significantly affect the economy as well as relative investment values.

You can view bond yield curves in many ways. Probably most useful for a bond manager is the curve between two and 10 years, because that's where the bulk of tradeable bonds lies.

Corporate bond yields are normally expressed in terms of how much more they yield than comparable Treasuries. This spread is measured in basis points, or 1/100ths of a percent. For example, the 10-year Treasury is now yielding 5.12%, and a similar maturity investment grade corporate is yielding 6.92%, so the corporate would be trading at a spread of 180 basis points.

Since early last year, corporate spreads have been historically wide. They gradually tightened this year, but then gapped out in September. After Sept. 11, a typical investment grade bond's spread jumped from about 155 basis points to about 195 basis points because of insurance company selling and a worsened credit outlook. Since the start of November, this spread has contracted to about 170 basis points.

However, different parts of the curve have behaved differently. Since early November, a typical two-year investment-grade corporate bond's spread has narrowed by only 10 basis points, while a 10-year issue has narrowed by 30 basis points. Longer bonds have benefited more from the prospect of an improving economy and from the end of the worsening year-end financing situation.

Impact on the Economy

I expect the economy will begin to recover in the first half of 2002, but I don't think the expansion will be very strong. The recent rise in bond yields likely will make it harder for the economy to accelerate. However, that rise will probably have a less negative impact on the economy than the Treasury market would imply, because of the flattening corporate bond yield curves.

While the yield on the 10-year Treasury has climbed 74 basis points since the end of October, the cost for a typical investment grade corporation to borrow for that term has risen by only about 44 basis points. This is a much smaller increase in the cost of capital investment than what some might infer from just looking at the Treasury market. It's also partly why I think the rise in yields will only limit the economy, not choke it off.

Bond Valuation

After the rally that followed the Treasury's Halloween decision to stop issuing the 30-year bond, I cut my long Treasury weighting and shifted to shorter corporates, trading maturity risk for credit risk. Even though corporate spreads have tightened in the past month, I still find them attractive because they're at a historically wide level.

The flattening of the corporate curve increases my bias to intermediate corporates, because you're getting paid less to take on the risk of a longer maturity. Whether you prefer short or long maturities, though, I think corporates are poised for another good year.

Corporates started off the year with wide spreads, which enabled them to outperform most other bond categories in 2001. Investment grade bonds returned between 8.5% and 10%, and high yield returned about 5.45%. The current spread levels, which are still high, will give corporate holders the chance to earn a decent amount of income.

If other bond managers follow Pimco's lead by shifting to "spread" products, including mortgages and emerging markets, they could push up prices in those sectors and thus produce some capital gains as well.