Long Bond's Goodbye No Short Cut for Corporates

The peg is slipping as the Treasury kills the 30-year.
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Debate has been rife about the Treasury's intentions in eliminating the long bond, with every theory from propping up stocks to subverting hedge funds' semi-obscure bets getting attention.

One thing it definitely did do was dramatically drop yields on 30-year government bonds, something the

Fed had been unable to accomplish on its own via nine rate cuts. That led people to reason that the government wants to cheapen long-term corporate borrowing rates, which are generally pegged to the bond, and help spur economic recovery.

Interest rates have fallen on corporate debt in the wake of the announcement, but nowhere near as sharply as they have on Treasuries. More importantly, lower borrowing rates won't encourage much new capital spending, at least not by themselves.

While corporate bond issuance has been brisk lately, most corporations still can't afford to issue the kind of debt most sensitive to the Treasury's move -- debt of 20 or more years in maturity. And those that can are doing it to refinance short-term paper or simply to hoard cash, not because they want to splurge on new technology or a new plant.

"There's been a huge exaggeration of how important this could be," said Bill Dudley, director of U.S. economic research at Goldman Sachs. "The private sector doesn't run on 30-year money. The consequences of this for the private sector are very, very modest. Capital spending is not being inhibited by rates, but by a lack of demand and corporate cash flows," he said.

Unyielding

Following the elimination of the long bond last week, 30-year Treasury yields have fallen 36 basis points to 4.85%. Yields on corporate bonds with maturities of 25 years or more have come down, but not as fast: about 18 basis points to 7.14% for top-rated issuers.

Most U.S. companies can't issue 30-year debt because their credit ratings make it prohibitively expensive. "Some of your stronger, highly visible, well-known companies can raise money out that far, but smaller companies, which are the bulk of the economy, can't do that. Lower 30-year rates isn't really an issue for them," said Credit Suisse First Boston bond strategist Mike Cloherty. It's the big blue-chips like

IBM

(IBM) - Get Report

that tend to borrow over the long term.

But even those who are issuing long-term debt are unlikely to shell out a lot of cash for big projects now. Most firms still have excess inventory to get rid of before they can think about investing in new products. And demand continues to fall. Capital spending fell 11.9% in the third quarter, according to the Commerce Department.

The flurry of bond issuance also represents companies whose shorter-dated paper has been downgraded and who are being squeezed into longer maturities.

General Motors

(GM) - Get Report

,

Eastman Kodak

(EK)

,

Corning

(GLW) - Get Report

and

AT&T

(T) - Get Report

all recently lost top-tier debt ratings on both commercial paper and bonds.

Others are simply amassing cash for later. "You might see some of this opportunistic issuance, where it's somebody who doesn't need the cash today, but likes how low the rates are on some of the debt they could issue," said Cloherty. "Getting cash in the hands of these firms should help, but any increases in capital spending will be small. Some of the big capital spending in recent years was by telecoms and other tech-type firms, and they're in a very different financial position than they were then."

The events of Sept. 11 only exacerbated the capital spending situation. "Uncertainty has exploded," said Cloherty, "which makes it a lot harder to justify building a new factory or undertaking a dramatic capital improvement," he said.

The 30-year bond used to be a proxy for the long end of the market, so its elimination creates a vacuum. A new proxy might be created out of high-grade corporate and agency issues, which would create another round of artificial demand and send rates even lower.

"No matter what, there's less competition, but a benchmark would help if one is created, because the members would benefit. The people that normally would have bought Treasuries will buy the benchmark security, which would take its place in terms of demand," said Cohen.

The situation is something like what happens when a stock is added to a popular index: Prices get bid up for no real reason, and fundamentals are forgotten, at least temporarily. With the government spending itself into a deficit and few signs emerging that demand has improved, it remains to be seen what the fundamentals will mean for long-term debt when the current Treasuries situation settles down.