Credit Markets Overview: Latest Interest Rate Rumblings

Editor's Note: This week we introduce a monthly feature of Fixed-Income Forum, the Credit Markets Overview. Its purpose: To explain the trends that are determining interest rates for individual investors -- from bond and bond mutual-fund yields to money-market and mortgage interest rates.

---

The credit markets in the fall of 2000 are in many respects a land of extremes. Nowhere is this more apparent than in the high-yield bond market, where amid weakening corporate earnings and falling stock prices, the default rate has moved up to its highest level since the start of the last recession in 1990.

Accordingly, investors in junk bonds have demanded higher yields as compensation for the risk of defaults. The average junk-bond yield is over 12% for the first time since the early 1990s. Fat yields on junk bonds have boosted the median yield of retail high-yield bond funds to 10.37%, according to Lipper.

Meanwhile, the Fed's aggressive stance on monetary policy -- the fed funds rate at 6.5% is the highest it's been since 1991 -- has simultaneously boosted yields on money market funds and quelled inflation fears to the extent that long-term Treasury yields are at or near their lowest levels in a year. That's good news if you're shopping for a mortgage -- mortgage interest rates are linked to long-term Treasury yields.

Let's have a look around.

Treasuries

From a long-term perspective, Treasury yields are right in the middle of their range, at levels around 6%.

Treasury Yields -- The Last Decade

More recently, Treasury yields have been moving steadily lower (as bond prices move higher). The rally has made Treasuries one of the best-performing financial assets of the year. Through the end of September, the Lehman Treasury Index returned 8.10%, compared with the S&P 500 index's 1.39% loss.

Treasury Yields -- The Last 2 Years

Fed Actions

The Treasury rally picked up speed in mid-May -- right around the time the Fed engineered its sixth and last hike in the fed funds rate since June 1999. The 50-basis-point move from 6% to 6.5% marked the first time since 1995 that the central bank moved rates by an increment larger than 25 basis points .

The Fed Funds Rate Target

Interest rate hikes by the Fed are negative for the bond market at first. But after a series of hikes, investors anticipate slowing economic growth and the end of the rate-hiking cycle. At that point, they start to buy Treasuries again, sending yields lower.

From June 1999 to May 2000, the Fed hiked the fed funds rate by a total of 175 basis points, from 4.75% to 6.5%. A small majority of economists expects that it will go no higher in the foreseeable future. According to a poll taken by Reuters on Oct. 6, economists at 15 of the 29 primary dealer firms think the Fed will either leave the rate unchanged at 6.5% through the end of next year, or that it will lower the rate in that time frame. The other 14 economists think the economy is still running at a pace that threatens to lead to higher inflation. They expect a rate hike at some point by the end of 2001, with four expecting the hike this year.

The Federal Open Market Committee , the Fed's monetary policy arm, next meets on Nov. 15. (Find the complete schedule on the Fed's Web site.)

Money Markets

High short-term interest rates have boosted returns on cash. The median retail money-market fund yield was 5.42% in September, the highest since December 1991.

Returns on Cash The average retail money-market fund yield

Source: Lipper

The Treasury yield curve is still inverted, with most long-term yields lower than most short-term yields. But that situation began to reverse in September. Long-term yields rose while short-term yields improved as investors contemplated the potentially inflationary effects of rising energy prices.

Mortgage Rates

Mortgage interest rates, like Treasury yields, are in the middle of their long-term range, at levels around 8%.

30-Year Mortgage Rate -- The Last Decade

Source: Federal Reserve

But also like Treasury yields, they are at or near their lowest levels in a year. Freddie Mac's average 30-year mortgage rate, the one tracked here, fell below 8% in mid-August for the first time this year.

30-Year Mortgage Rate -- The Last 2 Years

Source: Federal Reserve

Mortgage interest rates are a function of the market prices of mortgage-backed securities , which generally rise and fall with Treasuries because both classes of securities entail minimal credit risk .

Corporate Issues

Meanwhile, types of bonds that entail more than minimal credit risk -- specifically, corporate and high-yield bonds -- have been punished by the market to varying degrees.

This is consistent with declining corporate earnings, which weaken the ability of corporate borrowers to service their debt, prompting investors to demand higher yields.

The average investment-grade corporate bond traded at a yield of 7.66% in September, according to Merrill Lynch. In May, the average was over 8% for the first time since 1994.

Investment-Grade Bond Yields and Spreads The yield of the Merrill Lynch Investment-Grade Master Index, and its spread over the 10-year Treasury note

Source: Merrill Lynch

The averages aren't pretty on an absolute basis, but compared with Treasuries they're downright ugly. That is to say, the difference in yield between corporate and Treasury bonds is even higher than it was in the fall of 1998. Then, investors fled credit risk en masse, and stampeded into Treasuries. As a result, Treasury yields fell sharply, while all other bond yields spiked. The difference in yield between the average corporate bond and the 10-year Treasury note swelled to 174 basis points in October 1998.

The same spread was even higher last month at 186 basis points. This is in some measure attributable to the shrinking supply of Treasury securities, which has increased their value. The federal government has been spending its budget surplus on buybacks of Treasury securities. This has been a factor in this year's rally.

Even though the shrinking supply of Treasuries makes the difference between corporate and Treasury yields larger than it would otherwise be, the fact that it is at extremely high levels by historical standards still casts a pall over the market.

High Yield

The high-yield bond market is in even worse shape on an absolute basis, with the average rate of 12.45% in September the highest (apart from May's average of 12.47%) since the last recession, in 1991.

High-Yield Bond Yields and Spreads The yield of the Merrill Lynch High-Yield Master Index, and its spread over the 10-year Treasury note

Source: Merrill Lynch

This is a function of the rate at which high-yield borrowers have been defaulting on their debt. As measured by Moody's Investors Service, 6.15% of high-yield borrowers defaulted in August, the latest month for which numbers are available. Default rates higher than 6% haven't been seen since the last recession, when they peaked at over 12%. Moody's is forecasting that the rate will continue to rise.

Corporate Bond Default Rate

Source: Moody's

Munis

Finally, a peek at the municipal market. The trends here are similar to those in the Treasury market, which is not unusual. Munis entail more credit risk, but they are government bonds. The Bond Buyer 20-Bond Index's yield of 5.62% in the second week of October is low by long-term historical standards.

Municipal Bond Yields -- The Last Decade Yield of The Bond Buyer 20-Bond Index

Source: The Bond Buyer

Like Treasuries, munis have rallied this year. Still, yields are substantially higher than they were a year ago, when the index yield stood at 5%.

Municipal Bond Yields -- The Last 2 Years Yield of The Bond Buyer 20-Bond Index

Source: The Bond Buyer

---

Send your questions and comments to [e-mail], and please include your full name. Fixed-Income Forum appears each Friday.