Inflated by Y2K Fears, Bond Spreads Float Without a Pin in Clear Sight

Most believe the gap between Treasury yields and high-grade bond yields will narrow significantly, but no one can agree on when.
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Though just about anyone on Wall Street will tell you that year 2000 worries are overblown, it's surprising how few people are ready to put their money where their mouths are.

In recent months, the bond market has been groaning under a glut of corporate supply. Company treasurers are keen to raise emergency funds in case problems arising from the Y2K computer glitch are worse than predicted. And worried that investors may shy away from the market as the year closes, they've been rushing to issue debt. So far this year, $240 billion in investment-grade corporate bonds has been auctioned off, compared with $218 billion at this point last year, according to

Thomson Global Markets

.

"There's been this rush to get financing done just because of the uncertainty about the ability to price things in illiquid markets at year-end," says Mike Cloherty, senior market economist at

Credit Suisse First Boston

. While some kinds of short-term debt will continue to come to market through the end of the year, "the standard, normal financing -- all that's going to be done by year-end."

That makes for a buyer's market -- and not just for corporates. The yield on the

Fannie Mae

(FNM)

10-year bond, for example, has lately been trading more than 80 basis points above the 10-year Treasury yield. Last October, when you may recall credit markets seized up because the world was going to end, that spread only widened to 62 basis points. An opportunity? With the yield on the Fannie Mae that high, "if you're a long-term investor, you're almost crazy to buy Treasury bonds," says John Lonski, senior economist at

Moody's Investors Service

.

Getting Wider
Spread between 10-year Treasury and AAA-rated
corporate yields, in basis points

Source: Merrill Lynch

Just about everybody expects spreads between Treasury yields and high-grade bond yields to narrow significantly. If you start asking about

when

that's going to happen, though, you run into a bit of disagreement.

"It's going to be a while before those spreads come back in line," contends Steve Roach, chief economist at

Morgan Stanley Dean Witter

. "It's inconceivable to me to believe that investors will dismiss the risks associated with this event before the event takes place."

Other factors may be making investors hold back from putting money on spreads narrowing. For one, the speculative community is still licking its wounds over last year, when it bet that spreads between emerging-market debt and U.S./Japanese government debt would narrow, and it did the exact opposite. And though spreads between corporates and Treasuries have narrowed a bit recently, there's a chance that now that the

Fed

meeting is over, there could be one more big raft of corporate supply.

Yet to think that corporate bond yields won't come back in line until after the fourth quarter seems to go against the way markets work. There is always someone anxious to get in first. "People will anticipate a rally in 2000," says Bill Dudley, director of U.S. economic research at

Goldman Sachs

, "and people will jump the gun."

For some, it's something of a surprise that investors aren't already well off the blocks on this one.

"There are very few risks in the spread trade," says Tony Crescenzi, bond market strategist at

Miller Tabak Hirsch

, who thinks larger players will start nibbling on the trade over the next month. That will act as a catalyst, and then things could really get rolling.

"Buying will beget buying, and spreads will come in more," says Crescenzi. "Once it starts, it won't stop."