As we approach the presidential election, there seems to have developed an air of great expectations in the bond market that is hard to put one's finger on. Even though a Reagan victory is already in the market, it keeps surging onward and up. There seems to be a feeling that the Federal Reserve just might ease credit a little more after the election to aid a hesitating economy, and interest rates will fall a bit further. Or perhaps its the idea that the president, whoever he may be, will finally do something about the federal budget officials.
But one thing is for sure, this has not been a market that investors or speculators have been successful in "shorting." Shorting is a ploy that is engaged in because participants feel that bond prices, for whatever reasons, will decline. To take advantage of such a move, a dealer may sell a particular issue he does not own at a price, say $1,000, and then borrow that issue to make delivery to the buyer. If all goes well, he will then purchase at a later date, the issue he shorted at, let's say $995.00, for a half-point profit. He will then deliver that issue to the person from whom he borrowed the issue, pay him a fee for having borrowed the bonds, and what is left is his net profit. Conversely, should the market advance, the dealer would be forced to eventually "cover" his short position by purchasing the bond at a higher price, say $1,002.50. In this case, he looses a 1/4 of a point and, still incurs a borrowing cost. With the present strength in the market, plus the "great expectations," several dealers have gotten squeezed and were forced to cover their short positions. This in itself drives bond prices higher and is a technical factor that must be considered.
An interesting aspect in the surge of the government bond market has been its relationship to the municipal market. During the past two months, the muni market has been inundated with a heavy supply of new issues. Since the new issues have been so numerous, what doesn't get sold is simply carried as inventory, and the underwriters quickly move on to the next deal. The outgrowth of this activity has been that the dealers inventory -- which is advertised daily in a trade publication, the Blue List -- hit a record high last week of $1.86 billion in unsold bonds. In essence, this inventory is in competition with the new issues that are being marketed. The bottom line is that the taxable Treasury market has outperformed the muni market during the current rally while the muni market suffers from indigestion.
This misfortune has created opportunities for tax-exempt bond buyers. On a relative basis, the tax exempt return or yield on a revenue bond as a percentage of the yield or return on a similar Treasury maturity is at its high for the year. For example, if the yield on a 20-year Treasury is 10.00 percent, a 20-year, A rated, electric revenue bond is returning 9.27 percent. During the past year, the minimum ratio would have been 79.1 percent, while the average was 83.7 percent. This means that single-A rated, 20-year electric bonds are "cheap" compared with 20-year Treasuries.
The Treasury will offer three issues this week in its quarterly refunding. A 3-year note, in minimums of $5,000, will be offered on Monday. A 10-year note will be offered on Wednesday and a 30-year bond will be sold on Thursday. The latter two issues will be in $1,000 minimums. They should return 11.10 percent, 11.60 percent and 11.50 percent respectively.