Curve Favors Short-Term Debt as Fed Prints Cash: Credit Markets

Investors are favoring shorter-maturity corporate debt over longer-dated bonds by the most since credit markets froze, wagering central banks will succeed in sparking inflation.

The gap in relative yields on bonds issued by companies worldwide maturing in less than three years and debt due in seven to 10 years has widened to 47 basis points, or 0.47 percentage point, almost double the difference on June 30 and the widest since Sept. 19, 2008, according to Bank of America Merrill Lynch index data.

Rising speculation the Federal Reserve and the Bank of England will purchase bonds to inject cash into the U.S. and U.K. economies is triggering concern the cost of goods and services will rise. Investors are safeguarding more of their holdings in the shortest-dated notes because prices of the debt are less sensitive to inflation.

“We’re not sure when, but we do know that there will be a painful re-evaluation as a result of inflation and subsequent rate rises,” said James Lee, a fixed-income analyst at Calvert Asset Management in Bethesda, Maryland, with $14.7 billion in assets. “Investors are starting to position themselves for inflation with more shorter-dated and medium-term bonds.”

Bond traders’ inflation expectations in the U.S. for the next five years, measured by the breakeven rate between nominal and inflation-indexed bonds, rose to 1.46 percent from a one-year low of 1.13 percent on Aug. 24. The rate of inflation in the U.S., excluding food and energy costs, was 0.8 percent last month.

‘Flooding the System’

“You’ve got a massive amount of Treasury supply, you’re flooding the system globally with liquidity and a second quantitative easing that will put long-term inflationary pressure on the market,” said Greg Haendel, a money manager who helps oversee about $8 billion in fixed-income assets at Transamerica Investment Management in Los Angeles. “You’re definitely being paid to hold short-dated corporate bonds.”

Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar maturity government debt rose 1 basis point to 169 basis points, Bank of America Merrill Lynch’s Global Broad Market Corporate Index shows. Yields averaged 3.428 percent yesterday from 3.416 percent on Oct. 19.

EBay’s Debut Offering

EBay Inc., owner of the second-most visited e-commerce site, plans to sell $1.5 billion of debt in its first offering, taking advantage of record-low borrowing costs. The bonds may be issued as soon as today, a person familiar with the transaction said. The San Jose, California-based company’s board approved a debt sale “to capitalize on historically low U.S. interest rates and maintain financial flexibility,” Chief Financial Officer Bob Swan said yesterday on a conference call with analysts.

The cost of protecting corporate bonds from default in the U.S. fell. Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 1.2 basis points to a mid-price of 96.6 as of 12:18 p.m. in New York, according to index administrator Markit Group Ltd. The Markit iTraxx Europe Index of 125 companies with investment-grade ratings decreased 1.9 to 99.4.

Credit swap indexes typically fall as investor confidence improves and rise as it deteriorates. Contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Spreads on the shortest-dated corporate bonds are tightening at the fastest pace of all maturity groups, according to Bank of America Merrill Lynch index data. Notes due in one to three years yield 140 basis points more than government debt, down from 180 basis points on June 30.

Spread Narrows

In the same period, the average spread on seven- to 10-year debt narrowed 18 basis points to 187, while on bonds due in 10 years or more it shrunk 12 basis points to 192, index data show.

Even as spreads tighten faster on the shorter-term debt, returns have lagged behind because yields are at record lows. The one- to three-year debt has gained 1.7 percent since midyear, compared with 6.2 percent for the seven- to 10-year bonds, according to the indexes.

Central bankers are concerned a general decline in prices would hamper investment and further hinder the economic recovery. The U.S. economy expanded at a “modest pace” in September and early October with little sign of accelerating and companies still hesitant to hire, the Fed said yesterday in its Beige Book business survey by the 12 regional banks.

U.S. gross domestic product will grow 2.4 percent in 2011, slowing from 2.7 percent this year, according to economists surveyed by Bloomberg. In the U.K., growth of 1.9 percent in 2011 would follow 1.6 percent this year.

Bernanke on Stimulus

Fed Chairman Ben S. Bernanke said Oct. 15 that additional monetary stimulus may be warranted because inflation is too low and unemployment is too high.

“There would appear -- all else being equal -- to be a case for further action,” Bernanke said in remarks to a Boston Fed conference.

“The Fed has been very clear in its mission to support the market and buy back Treasuries,” Calvert’s Lee said. “We have made a conscious effort to be overweight three- to five-year maturities, but we are looking at debt that’s shorter as well.”

Calvert started selling holdings of corporate bonds maturing in 10 years or more about six months ago in favor of shorter-dated debt, Lee said.

Zero Percent

Bank of England policy makers are also starting to lean toward further emergency bond purchases to shore up the country’s recovery. On Oct. 19, Governor Mervyn King signaled he may be open to stepping up asset purchases from the current 200 billion pound ($317 billion) limit to prevent deflationary pressures in the economy. The Bank of England voted this month to keep its main rate at 0.5 percent.

Investors shouldn’t be concerned the central banks’ so-called quantitative easing will spur a rise in the inflation rate in the near term because U.S. and European economies remain so weak, said Sanjay Joshi, who oversees about $500 million as a money manager at London & Capital in London and is buying both short- and long-term debt. Even as today’s industry data showed a better-than-forecast result for European manufacturing, a separate index showed services remain weak.

“In an era of high unemployment, low wages and deleveraging, inflation is likely to remain low for many quarters ahead,” Joshi said.

Interest Rate Surge

Any acceleration in inflation would also lead to a surge in interest rates, said Steven Mitra, partner at LNG Capital LLP, which is raising as much as $100 million for a new European credit fund. Six-month and one-year notes “should act as a natural hedge” against price volatility, he said.

The Fed has kept short-term interest rates at a record low between zero and 0.25 percent since December 2008 to encourage the country’s economic recovery. Futures traders have placed more than 78 percent odds that the central bank won’t increase rates through November 2011.

“Once the economy gains footing and investor confidence improves, I think there could be a pretty fast snap-back in rates,” Haendel said. “And there’s going to be a lot of pain for those who aren’t positioned correctly.”

Download: Stiglitz on the U.S Economy, Kaufman on Inflation: Audio


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