Ever see a battleship turn on a dime? The bond market did just that this past week. Just when it looked as if the bond market was in the process of loosing ground, the Treasury announced on Monday three coupon offerings to raise $17.75 billion in new money during the week. The market declined at first and then began to pick up steam, so that when the 4-year note was auctioned on Tuesday, it attracted $34 billion in bids for the $6.75 billion issue. The demand produced an average return of 9.47 percent. By the end of the day, the issue showed a profit, trading in the 9.38 percent area.
The reasons for this quick turnaround are several. Foremost was the fact that there had been no coupon issues, other than a 2-year note, since Aug. 28. This led investors to earmark a greal deal of money for any new coupon issues. Some dealers were quick to realize this fact and, as a result, they "bulled" the first auction by bidding so aggressively that the New York Federal Reserve District, in which most of the dealers are domiciled, purchased 91 percent of the 4-year issue. In the process, they forced other dealers and speculators who had "shorted" the market to cover these shorts, which gave added impetus to the rally. At the same time, analysts were saying that the economy was much weaker than was perceived. This meant that the Federal Reserve could not tighten credit conditions or raise interest rates. All this generated an air of good feeling, which spilled over into the 7-year auction on Wednesday and produced an average yield of 9.75 percent.
But the truth of the matter is that the rally carried Treasury rates to the low levels of last spring. Dealers began talking of a cut in the discount rate, which is currently 7.50 percent. With the market trading on this expectation, it would seem plausible that, if the cut did not materialize quickly, the market would give back some of its gains. This would be especially true in light of the three-issue November refunding, which could come this week, and in which $22 billion of new money must be raised. Should the Treasury surprise us by announcing a 3-year and 10-year note, plus a 30-year bond to sell this week, they should return 9 percent, 10 percent and 10.25 percent respectively.
Another opportunity is presenting itself in the municipal market. Heavy buying of high-grade general obligation (GO) bonds by commerical banks, especially in the 10-year to 15-year maturity area, has caused interest rates on those types of bonds to fall dramatically. By the same token, the tidal wave of new revenue issues, on a relative basis, has allowed the returns on revenue bonds to fall at a much slower degree. This means that the yield spread, as measured by the Bond Buyers' GO index and revenue bond index, is now at its widest point of the year -- 64 basis points (a basis point is one one-hundredth of a percentage point). An investor would be wise to sell high grade GOs and purchase quality revenue issues at the current wide spread. The investor either may stay with the higher-yield situation of the revenue bond, or reverse the trade when the yield spread narrows. If the tax-reform legislation is passed as advertised, many of the various types of revenue issues will be eliminated, which means the spread between GOs and revenue bonds could narrow to historic levels.