Bond market participants were treated to another week of outstanding performance as interest rates continued to fall. The decline of short-term rates outpaced other areas of the market, but yields continued to tumble in the longer coupon issues as well.
Just when it looked as if the market had run out of gas on Thursday, the Federal Reserve swapped $450 million of coupon notes due in September 1982 for a like amount of five- to seven-year paper. This proved extremely beneficial to the Treasury market, adding supply where it was scarce and taking it from the intermediate area where the yields were higher and the securities more plentiful.
On top of that, inter-dealer chatter on Wall Street began to disseminate rumors that Salomon Brothers' famed interest-rate guru Henry Kaufman had turned bullish on interest rates, which immediately propelled bond prices to new highs for this rally. Actually, Kaufman predicted that rates would continue to decline near-term, especially short rates, but in a few months, as the recovery moved forward, rates would be reversed and move much higher--a position he has held all along, but the market was just looking for a reason to improve.
The downward thrust of rates has now shaped a very positive yield curve. In other words, when you move out from one maturity to another, you are able to pick up or increase your yield. Therefore, an investor may sell a three-month Treasury bill, on a discounted yield basis of 10.35 percent, and purchase the two-year note at 13.03 percent and increase yield by 268 basis points. Or, the investor could continue on out the yield curve to the 30-year Treasury bond and buy it on a 13.19 percent basis, for a pick-up of 284 basis points.
With a positive yield curve and with investors willing to extend to pick up yield, corporations are now in a position to unwind their heavy short-term indebtedness by lengthening maturities. Within the past two weeks, corporations have taken advantage of this situation by selling $3.3 billion worth of longer maturities. Of that amount, $1.9 billion had a stated maturity or an extendable maturity of five years or less; $940 million more than out to 10 years, while only $475 million could be considered long-term bonds.
The overall financing strategies of these corporations is to extend their short debt as long as possible at a fixed rate, as opposed to constantly rolling over short-term commercial paper at a high interest rate, or renewing bank loans that are tied to the 16 percent prime rate. With this in mind, the corporations structured their financing as mentioned above for two reasons.
First, with interest rates being so volatile and with many economists like Kaufman predicting a return to higher rates, the corporations wanted to extend where possible some debt just to hedge their commercial paper or bank-loan borrowing--a sort of "get your foot in the door" approach. With funds generated from these sales, part of the very short-term indebtedness is then reduced.
Even though rates have fallen dramatically, on the historical basis, nominal and real interest are still very high and borrowers do not wish to tie themselves into these high rates, if possible, for any long length of time. So when rates have declined further, they will sell seven- to 10-year maturities. And finally, when long interest rates have declined a great deal more, they will market long-term 30-year bonds.
The second reason for this approach is that the buyers' preference, at this time, is to purchase only short-term maturities, just in case rates do rise again. This allows sellers and buyers to solve two problems at once.