Investor 007's Bond Dossier

Meet Investor 007. His specialty? Bonds. Fixed-income bonds.

Don't be fooled by their low-profile reputation. Beneath that cunning disguise, bonds are sophisticated tools to help safeguard your portfolio from the perils of riskier investments. Here's the latest intelligence on their high-stakes world. If you're new to the game, get briefed on the basics of Investor 007's business, or check out our Bond Center for some useful gadgets to help ensure a successful investing mission.

Spying on rates
The benchmark U.S. Treasuries are key rates to keep under surveillance. Corporate issues are generally priced at a spread to a Treasury rate with a similar term, based on the issuer's credit rating.

U.S. Treasury

Price

Yield

2-year

$100 26/32

4.17%

5-year

$101 5/32

4.35%

10-year

$100 15/32

4.69%

30-year

$99 30/32

5.00%

Clues to the market
The broad credit market is influenced by a host of macroeconomic factors. Another flight to quality occurred again last week, as global markets approached panic and the Federal Reserve stepped in with a surprise discount rate cut. For the week, the particularly interest rate-sensitive two-year note yield plunged 28 basis points to 4.17%, while the benchmark 10-year yield dropped 12 basis points to 4.69%, and the 30-year yield slipped 4 basis points to 5%. Bond prices move inversely to yields.

Jitters about the state of financial markets predominated last week and overshadowed economic data. Despite reports of a rebound in consumer spending and retail sales on Monday, an early equity rally faded because of credit concerns and gave way to Treasury gains. The benchmark 10-year yield dropped 3 basis points to 4.76%. Treasuries rose again on Tuesday during a session marked by liquidity worries. The two-year yield dropped 6 basis points to 4.35%, a nearly 18-month low, as speculation of an interest-rate cut increased.

A downgrade of Countrywide Financial (NYSE: CFC  ) and its potential bankruptcy took center stage on Wednesday. The two-year Treasury yield dropped to 4.28%, and the 10-year yield remained essentially flat at 4.72%. As the global equity rout intensified on Thursday, the two-year yield fell to 4.20%, and the 10-year declined to 4.65%. Treasury bills attracted buyers, and the three-month yield tumbled to 3.98% as companies found it increasingly difficult to roll over short-term debt. A bleak view of the housing situation compounded worries, with housing starts dropping to their lowest level in 10 years.

The Fed stepped in early Friday with a 50-basis-point reduction to the discount rate, which is the interest rate it charges banks. It now stands at 5.75%. Marking the first time since 2001 that it has reduced borrowing rates between scheduled meetings, the Fed acknowledged the rising threat to economic growth stemming from the subprime problems. Stocks soared, while two-year yields slipped another 3 basis points on heightened expectations for further cuts to come at the Sept. 18 Federal Open Market Committee meeting.

Detecting developments
Investor 007 noted the following occurrences in the bond market last week.

  • ABX indexes, measures of subprime health, sank to record lows on Thursday.
  • Buyout firm Kohlberg Kravis Roberts acknowledged in its IPO filing that the cost of high-yield debt issuance has significantly increased and may hurt its financial results.
  • Canadian asset-backed commercial paper issuers came under pressure on Tuesday, as banks refused to supply emergency financing. A group of lenders stepped in on Thursday to ease the crunch.
  • Companies issuing debt in the public market included:
    • Johnson & Johnson (NYSE: JNJ  ) , which sold $2.6 billion of debt in a three-tranche offering consisting of five-year, 10-year, and 30-year securities; this figure increased in size from the original $1.5 billion.
    • Safeway (NYSE: SWY  ) , which sold $500 million in 10-year notes, a figure that increased in size from $400 million.
    • Wal-Mart (NYSE: WMT  ) , which sold $2.75 million of debt in a two-tranche offering consisting of 10-year and 30-year securities.

Hot tip
Last Monday, the federal fund rate traded at 5 5/16%, above the Fed's target rate of 5 1/4%. The following day, the same rate traded at 4%. In fact, during the last two-week period, the Fed funds rate has traded between 0% and 6%. However, instead of signaling that the U.S. financial system was broken, the volatility displayed the system's strength and flexibility.

The Fed typically uses overnight repurchase agreements, or repos, to inject liquidity into the market. Repos allow the Fed to purchase Treasuries and mortgage-backed and agency debt from its primary dealers for a certain period; doing so raises the amount of money flowing through the financial system. At maturity, the cash is returned to the Fed, and the securities to the dealers.

Lately, the Fed has used repos to counteract an excessively restrictive lending environment arising from the subprime crisis. Many European and Asian central banks, as well as the Fed, had begun pumping liquidity -- totaling about $350 billion since Aug. 9 -- into the market the previous week as markets tumbled.

When Fed funds trade below the target rate, it signals an abundant supply of inexpensive cash in the market. Conversely, trading above the target rate indicates an increasing demand for credit and diminishing supply. Conducted through the Federal Reserve Bank of New York, the Fed's open market operations don't qualify as an official policy shift, even if they function as a de facto easing. By checking the policy statements on the FRBNY's website, you can stay on top of developments -- but you still won't be tipped off to know when a surprise rate cut is coming!

Johnson & Johnson is a Motley Fool Income Investor recommendation. To learn more about adding the right dividend-paying stocks and income-producing bonds to your portfolio, give Income Investor a try, free for 30 days.

Fool contributor S.J. Caplan has been an undercover fixed-income aficionado ever since serving in banking and legal capacities covering debt underwriting as well as fixed income derivatives. She owns U.S. Treasuries and shares of the Fidelity Inflation Protected Bond Fund. Wal-Mart is an Inside Value recommendation. She prefers her portfolio shaken, not stirred. The Fool has a disclosure policy.


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