Liquidity Problems Don't Mean Another Crisis Is Coming

Fixed-income investors remain skittish, but it's just the throes of a market getting used to corporates dominating instead of Treasuries.
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What the heck is going on around here?

In the last few weeks, two different instances of unsubstantiated and sometimes bizarre rumors have resulted in investors flying headlong out of various credit markets into the safe confines of the Treasury market. These instances, including yesterday's rumor-induced buying, were a reminder that the market still hasn't entirely gotten over last year's Asian crisis.

Because of that crisis, the fixed-income markets are still averse to risk, and they're suffering from a lack of liquidity, or the ability to trade quickly and easily. But those factors are clashing with the record level of new corporate-bond issuance -- responsible for a widening in yield spreads (the difference in basis points between the yields on Treasury securities and those on corporate bonds) to Asian-crisis-type levels.

Some are pointing to the widened spreads and lack of liquidity as evidence that some kind of credit crisis could happen again. This running-scared mentality is exacerbated by fear that the

Federal Reserve

will continue to raise rates and by general worry about

Y2K

computer problems.

But some market watchers say the failure of spreads to snap back to precrisis levels stems from a shift in the credit market's makeup, from domination by Treasury supply to domination by corporate supply. The decline in Treasury supply -- which should continue for the foreseeable future -- is something the market is only now being forced to deal with.

Nobody's Trading

What's scared people this year is that technical factors -- or unproven rumors -- are resulting in violent one-day swings in the bond market, such as yesterday, when just about every dealer under the sun was rumored to have lost millions in derivatives transactions.

But the Treasury market has been volatile this year for a good reason -- nobody's trading. Dealers scaled back their volume after last year's crisis and haven't been willing to risk the same amount of capital as last year. On average, $75 billion of securities were traded daily in last year's third quarter, according to tracker

GovPX

-- compared with about 70% of that for an average day last month.

"It does give rise to a tendency to overreact to news and rumors," says Tony Crescenzi, chief bond market strategist at

Miller Tabak Hirsch

. "The long list

of those rumored to have lost money we had yesterday is just indicative of a market reaching for answers."

It's one factor in why corporate spreads have widened out. That and the market's being overwhelmed by more corporate deals than ever. Corporate-bond issuance this year so far totals $512 billion, compared with $502 billion through this point in 1998, according to

Thomson Global Markets

. Though some corporate treasurers are clearly loading up on capital now because they're worried about Y2K, sources believe this is bigger than a temporary Y2K phenomenon. They believe the spread widening is endemic of a market adjusting to a heavy, institutionalized level of corporate issuance and a continually shrinking level of Treasury sales.

The average triple-A corporate bond was, as of yesterday, trading at 95 basis points over Treasuries, compared with 78 basis points on Feb. 15, and 118 on Oct. 14, 1998, the height of the crisis. A 10-year

Fannie Mae

bond is currently trading at 90 over Treasuries, compared with 57 on Feb. 15 and 76 on Oct. 9, according to John Atkins, analyst at Thomson Global Markets.

"Whatever you think is going to be a normal spread, I think you have to bump it out and say, this is what it's going to be for the foreseeable future," says Margaret Patel, portfolio manager of the

Third Avenue High Yield

fund.

Since the 1980s, in the credit markets, it's been Treasury bonds first, everything else second. While the markets have been aware for several years that the federal government's fiscal prudence might diminish the importance of Treasury supply, until now the impact on other credit markets hasn't been discernable. But the Treasury has just cut back its 30-year bond auctions to twice a year, and may soon cut the sizes of its one-year and two-year auctions.

Meanwhile, there's an increasing number of companies selling more than a billion dollars in bonds at once. Last month,

Ford

(F) - Get Report

sold $8.6 billion in different maturities -- almost the size of a Treasury auction. "Think about what it would be like to have an auction every day," says Crescenzi.

This, ultimately, will help the market's liquidity, as corporate and Federal-agency debt is more clearly defined as a benchmarking tool.

Look at Off-the-Run

Crescenzi says the heavy level of issuance is one reason why he doesn't think the market is headed into a crisis -- last year the market for new issues froze. To him, the telling factor will be a rapid rise in the spread between current Treasury bonds, called on-the-run bonds, and older issues, or off-the-run bonds. Last year, the demand for the safest, most liquid asset resulted in a flight from even these older Treasury bonds, widening the spread between the then-current Treasury and the previous bond to 23 basis points, while now it stands at just 10 basis points.

Atkins cited the difference in spreads between high-yield bonds and higher-rated corporate bonds as evidence that the credit markets are merely struggling with the high volume of bonds, not evidence of a looming credit crunch. For example, he cited

NTL

(NTLI)

, which priced a junk-bond offering on Oct. 26, 1998, during the crisis, at 684 basis points over Treasuries, now trading at 400 over the 10-year note. "The lower-tier credits are not getting a disproportionate amount of the damage," Atkins said. "They're not getting pummeled quite as badly. Spreads are wide because of supply."

The Federal agencies are trying to establish their bonds as a benchmark for investors as the Treasury continues to pay down debt. Ford's underwriters have said they hope their recent global issue helps build a corporate repo market (the repo, or repurchasing, market is where dealers borrow Treasuries to use as a hedge, and it's currently just a Treasury phenomenon).

Of course, if the economy were to hit a recession, or were global conflict to necessitate a buildup in military spending, the direction of the market would revert to what it was in the '80s. Until that happens, the market's going to have to evolve.

"We've all known two years ago that there was going to be

continued lesser issuance of Treasuries," says Patel, "but what actually happens in the market can still surprise you."