Amid signs that the economy is beginning to turn, it might prove worthwhile to revisit the various sectors of the bond market and look at the various yield spreads in those sectors against U.S. Treasuries. Yield spreads generally follow a normal pattern during a business cycle. When the economy arrives at the end of a business cycle, a recession develops, and with it, a greater concern by investors about the ability of an issuer to meet his debt service requirements.
Generally, as the recession progresses and earnings become strained, the yield spreads of the lower quality bonds begin to widen against Treasuries, and against higher-rated bonds within their particular sector. But this isn't always true. Many investors try to time their purchases of lower quality bonds to coincide with the time when the spreads are at their widest point, near the end of the recession or at the beginning of the recovery. As the recovery progresses and issuers are able to strengthen their balance sheets, the spreads begin to narrow to their more normal alignment. At that point, the investor may sell his low-quality bonds and purchase a higher quality issue, at a much more narrow spread, or to put it another way, to purchase the higher-quality issue at a minimum cost.
Since the current high interest rate environment is unlike any we have passed through before, and since this environment is occurring at the end of 20 years of inflation, the previous guidelines and spread relationships have been rendered practically useless. Currently, overall yield levels are much higher than before, corporate balance sheets are in wretched condition, and states and municipalities find themselves under greater financial stress than ever before.
In the shortest end of the maturity spectrum, the yield spreads between the various qualities of commercial paper issuers has widened. The premier commercial paper carries the A1+/P1 rating, while its long-term debt may be rated AAA or AA. Two months ago the next lowest grade of commercial paper, rated A2/P2, returned 75 basis points more yield than the highest grade.
Long-term single B rated corporate spreads have widened slightly against long Treasury issues. In 1981 the maximum spread, which was around 450 basis points, has today become the average spread. In April, International Harvester bonds were yielding 25 to 26 percent -- or 1,200 to 1,300 basis points more than Treasuries. Today they are returning 30 percent, or 1,700 basis points more than long Treasuries. But this is an isolated situation and each single B or BB rated company must be analyzed on its own merits.
Triple-B rated industrials were returning around 210 basis points more yield than Treasuries a few months ago. Today that spread has narrowed slightly to 190 to 200 basis points. Similarly, the better BBB-rated public utility issues have recently seen their spreads narrow against Treasuries from 380 to 320 basis points. However, the reason for this unexpected narrowing is due to two technical considerations. First, the supply of new long term BBB utility or industrial issues has been small so far this year, about 12 percent of the new corporates sold. And secondly, while the Treasury market has fallen off so dramatically during the last two weeks, and Treasury yields have risen some 70 basis points, the corporate market has been slow to follow. Some corporate traders feel these yield spreads will become even narrower given the huge supply of Treasury debt that must be financed during the next six months.
The Treasury postponed last week's four-year note so that the four-year will now be sold on Tuesday, while a new seven-year note will be sold on Thursday. Both issues will come in minimums of $1,000.