Uncertainty of Dollar's Future Has Affected All Segments of Fixed-Income Market

For the past several months, the bond markets have been dominated by the direction of the dollar in the foreign exchange market.

In recent weeks the dollar has rallied in the foreign exchange market, and bond prices have moved higher. However, because the underlying fundamentals are still negative for the dollar, the bond market has run into difficulty as the dollar has moved to the resistance level of 150 yen. The uncertainty of the dollar's future, hence the direction of interest rates, has affected all segments of the fixed-income market.

The new-issue volume has slowed somewhat as long-term rates have moved higher in recent weeks. The higher rates have been responsible for the reduction in refundings, which through June have accounted for 53 percent of the total volume. In addition, $9 billion of short-term tax-exempt notes matured at the end of June and only $3 billion were re-issued, creating a shortfall of $6 billion.

With demand greater than supply, short-term rates have declined as much as 75 basis points. This factor, coupled with the narrowing of yield spreads between high-grade general obligation bonds and lower-quality revenue issues, has provided trading opportunities.

The decline in short-term rates has moved the yield spreads on AAA-rated general obligation bonds to historic levels between the one-to-five- and five-to-10-year maturity sectors. For example, during the past year, the average pickup in yield in going from the one-to-five-year AAA bond was 115 basis points, while the lowest pickup was 90 basis points. Currently the move can be made for about 125 basis points.

Similarly, in going from the five to the 10-year maturity AAA general obligation bond, the average yield pickup has been 85 basis points, the minimum 75. Currently the spread is about 100 basis points.

At the same time, the spreads have narrowed between high-grade and lower-quality revenue bonds. This means an investor can go from an A-rated 30-year housing, hospital or electric revenue bond into a 30-year AAA-rated general obligation bond at a minimum give-up of yield. For example, an investor could sell an A-rated electric revenue bond and buy an AAA general obligation bond with a give-up of 55 basis points. During the past year, the largest give-up would have been 85 basis points, the average 65 basis points.

The merits of such a transaction are that you upgrade from an A-rated revenue to an AAA general obligation with a minimum give-up in yield. When those spreads widen to their more normal relationships, they can be reversed at attractive pickups.

James E. Lebherz has 28 years' experience in fixed-income investments