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No Boundaries - To Bond Spreads


Wednesday's Heard on the Street column in the Wall Street Journal discussed the recent trading in Ford bonds. The article mentioned that some dealers were starting to price the paper in dollars and cents, not as a spread above Treasuries, which investment grade bonds are usually priced. Spreads have widened dramatically over the past week and it continued on Wednesday. Today as Treasuries lost 6.6 basis points, the yield on Ford 10-year bonds jumped 30 basis points. This 36 basis point widening over treasuries caps off an historic week that so far has seen the spread to treasuries widen 111 basis points in the last four trading days to 580 basis points over Treasuries. For a little prospective, Ford bonds traded around 200 basis points above Treasuries over the past 18-months before starting a complete decoupling this summer. General Motors' bonds have widened a similar 109.9 basis points since Thursday, with 42.5 basis points just today. It is not confined just to the automakers, Household's spreads have also widened dramatically. Its bonds widened 44.5 basis points today and 103.2 basis points since Thursday.

Looking at the spread historically it is amazing how wide they moved considering how low government bonds are yielding. Last year, Ford paper traded 200 basis points above Treasuries when Treasuries yielded 5%, making the spread about 40% of the Treasury. Now Treasuries yields are at 3.5%, so the 9.4% yield Ford traded at today is 270% above the Treasury. This does not make for a good trade if you shorted Treasuries to buy Ford paper. If a hedge fund put this trade on in mid-July when the spread was 250 basis points, which was the high side of a one-year trading range (200 to 250 basis points), the fund would have expected a standard deviation of 35 basis points. In the past four days it would have seen a three standard deviation move. For more prospective, during the Russian collapse in 1998. Ford bonds widened 47.7 basis points over a one-week span. As you might remember the Russian default set in motion the wheels to send LTCM over the edge. During this whole financial meltdown, Ford bonds widened from about 120 basis points over Treasuries to about 220 basis points, 100 basis point of widening. I'll repeat, Ford's bonds have widened 111 basis points in the last four trading days.

There is definitely something brewing in the credit markets. We also think the same stress is in the asset backed securities (ABS) market. All three of the above companies are also involved in the ABS market. If the ABS market is undergoing the same stress as the lower grade corporate bond market is displaying, it will not be long until the easy financing that consumers have grown accustomed to is withdrawn.

There has been little news this week. The only economic news so far has been the Fed consumer credit data. Jobless claims on Thursday will be watched with Friday offering a full plate of data including: producer price index, retail sales, and the University of Michigan Confidence all released. Most notably, Wall Street has been busy lowering earnings estimates for the third quarter.

The only piece of economic data released so far was the lower than expected consumer credit data released from the Fed Monday. While this could be evidence that the consumer is starting to retrench, the record about of refinancing (which is not included in the consumer credit number) could be masking weak consumer credit growth. A couple weeks ago I mentioned the possibility that consumers might actually act responsible during this refinance boom and not spend the amount cashed-out or the amount freed up due to lower monthly payments. At the time I admitted it was a bit of wishful thinking, but this week, Merrill Lynch said that its surveys found that 30% of those that have recently refinanced have used the freed up money to bolster savings, compared to only 2% in its 1998/1999 survey. More importantly it found only 30% were using the proceeds toward consumer purchases. This compares quite unfavorably to the 70% in 1998/99.

Market volatility has been wearing on investors. From conversations with several of the trading desks we use, it still seems that trading oriented hedge funds are accounting for a substantial amount of the trading. Longer term investors continue to sit on their hands and place bids in below the market, then pull them as they get hit. With investors hesitant to step up, volatility will continue to be the norm. With option expiration next week, volatility could get even more dramatic. Right now, puts on the major indexes are skewed to the put side. That has the potential to add downside acceleration, as the writers of those options have to hedge their position by shorting the indexes.

Trading over the next couple weeks could also be influenced by mutual funds squaring their books. The end of October marks the year-end for a lot of mutual funds and it will be interesting to see how they align their portfolios for their annual reports.

From talking to a few of the trading desks we work with it sounds like there is a lot of despair among investors. Everyone seems to be thinking the same thing, "how much longer can it last." After years of superficial analysis, investors are incapable of doing any valuation measures based on reality. At least the mentality of, "well it was $100 and now its $10 so it must be cheap," has worn off as the $10 price became $6, $4, $2… There is not a lot of bids under the market and when the bids that are there start getting hit, they are quickly canceled.

Bulls are sitting on their hands. A lot of value investors have experienced the worse returns in their lifetime. There just has not been anywhere to hide. Plus a lot of the value mangers walked into a value trap and had the stocks continue to trade lower. The S&P Barra Value Index has experienced its worse two quarter performance since it started, with the -20.9% third quarter return only topped by -22.7% return posted in the fourth quarter of 1987. This also marks the first time the index fell more than 5% in consecutive quarters. This market has obviously allowed short sellers to prosper. This adds a new dimension for how the market trades. Bears are sitting on decent profits this year and feel then can use up some of the houses' money to ride out the rallies or even sell into rallies. The past couple one-day rallies have given short sellers confidence. Up until just a week ago short sellers were timid about shorting on the lows. Plus, the fundamentals for the economy and individual companies are impossible to get excited over and appear to be getting worse. Please, don't construe that the market cannot rally. The market always seems to rally right when fundamentals look the worse. Usually this has been due to Fed easing. Will the Fed ease again, and if so will it matter?

Besides the undercurrents the credit markets are influencing the stock market, earnings will be the other driving force for the stock market. And unfortunately earnings targets have continued to drop. S&P500 earnings are now expected to be only 5.6% ahead of last year. Last week S&P 500 earnings growth for the third quarter was expected to be 7.3%. This is bound to be even lower as Wall Street analysts keep slashing estimates. What will be more telling is what companies disclose about their plans for the rest of the year and early next year. The economy has not picked up as so many anticipated at the end of the second quarter. In fact, it looks like it is losing steam. Today, Morgan Stanley lowered 2003 earnings estimates on General Electric and lowered GE's long-term growth assumption to 9% from 11%.

The financial markets are undergoing dramatic stress right now. Besides a weakening economy and falling earnings estimates, there is stress in the credit markets beyond anything we have seen in years. Stay tuned to see what develops, its guaranteed to be interesting.

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