Published August 30, 2013
NEW YORK – It's taken nearly five-years, but one of the most persistent bond market dislocations left behind by the financial crisis has finally dissipated, likely signaling that the days of super-cheap corporate borrowing costs are numbered.
In the latest signal of the slow normalization process playing out in U.S. financial system, the 30-year swap spread closed above zero earlier this week for the first time since January 2009.
The spread, the difference between the yield on the U.S. 30-year Treasury bond and the rate on an interest rate swap contract of the same maturity, reflects the risk premium associated with private borrowing relative to Treasuries.
Swaps allow a dealer and an investor to exchange interest payments based on a specific principal amount - one swapping payments at a fixed rate for payments at a floating rate. Swaps are used in a broad range of corporate finance, including to hedge future interest rate expenses and as collateral for other fund-raising. The market is vast, notionally valued at $370 trillion.
A negative spread had never before been seen until the collapse of Lehman Brothers nearly five years ago unleashed violent and long-lasting distortions across global financial markets. It also implied something previously unthinkable: the U.S. government, with its mushrooming debt load, was less creditworthy than some private borrowers.
On Wednesday, the swap spread closed at half of a basis point, or 5/1000ths of a percentage point, capping a grinding normalization underway for most of the last year. It held that level again on Thursday.
The move back to a positive spread picked up pace this summer as investors have grown increasingly convinced that the Federal Reserve will soon start scaling back on the $85 billion a month in bond purchases it has used to support the economy's recovery from the Great Recession.
"This is a cyclical move higher in rates that's causing spreads to widen," said Neela Gollapudi, Citi's interest rate derivatives strategist in New York.
In fact, the move to more typical rates in the swaps market is only the latest of several measures of financial market conditions that have been restored to near pre-crisis norms.
Other areas of the bond market also signaled traders looking at a world without additional Fed stimulus, which has held long-term yields near historic lows in a bid to support the economy recovery. The yield on l0-year Treasury Inflation Protected Securities moved into positive territory in June after being in the red for about 1-1/2 years.
Analysts said this rising rate trend could be interrupted by a resurgence in safehaven bids for bonds due to a possible U.S.-led military strike against Syria or another showdown between the White House and Congress over the debt ceiling.
Or a surprise from the Fed.
"It will be a huge shot for the market if they don't taper in September," said Mary Beth Fisher, head U.S. interest rates strategist at SG Corporate & Investment Banking in New York.
In the past couple of years, insurance companies and pension funds loaded up on these long-dated, over-the-counter products to make sure they have enough income to meet their payout obligation in anticipation that long-term rates will stay at their historic lows for a protracted period, analysts said.
Then, they cut back their long-dated swap holdings in the wake of a vicious bond market sell-off that started late May due to hints from the Fed that it might soon pare its monthly purchases of Treasuries and mortgage-backed securities. The sell-off pressured 30-year Treasury yields to two-year highs and increased the risk premiums on mortgage and corporate bonds.
"With the swift rise in rates, they are reversing those earlier trades," Citi's Gollapudi said.
Other factors behind the recent shift included the unwinding of a popular currency derivatives trade that came under pressure this spring when the Bank of Japan embarked on its own $1.4 trillion stimulus program.
"Japan was a big driver no question," said Anthony Valeri, fixed income strategist at LPL Financial in San Diego.
Whatever the cause, the changing dynamic likely augurs for higher corporate borrowing costs.
Should the Fed scale back its purchases as expected, long-term Treasury yields are likely to move yet higher and could begin reclaiming investor cash that had been forced to find yield in other assets such as corporate bonds.
That appetite helped feed record levels of bond issuance and record low borrowing costs for companies: The average coupon, or rate paid by the borrower, for an investment-grade U.S. corporate bond recently fell to a record low 4.7 percent, according to the Barclays Aggregate U.S. Corporate Investment Grade Bond.
Companies might rush to sell bonds in a bid to lock in these still historic low rates ahead of the Fed's next policy meeting on September 17-18 when it might decide to pare its bond purchases.
"September could be a heavy corporate issuance month," said SG's Fisher. "Companies are thinking: 'We might be at the end of low long-term rates.'"
(Reporting by Richard Leong; Editing by Dan Burns)