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 19/32

4.28%

5-year

100 29/32

4.41%

10-year

101

4.62%

30-year

101 23/32

4.89%

Clues to the market
The broad credit market is influenced by a host of macroeconomic factors. Treasuries turned in a mixed performance last week as signs of market stability began to emerge. For the week, the yield for the two-year note, which is particularly sensitive to the interest rate, gained 11 basis points to 4.28%, while the benchmark 10-year yield slipped seven basis points to 4.62%, and the 30-year yield dropped 11 basis points to 4.89%. Bond prices move inversely to yields.

Despite the Fed's surprise discount rate reduction the previous Friday, the credit market remained in panic mode on Monday. Treasury bill yields reflected the extreme rush to safety by falling the most in two decades, while investors dumped asset-backed commercial paper. The three-month yield ended at 3.15% by the end of active trading, after dropping to 2.51% at one point.

T-bills reversed course the next four days and yields rose amid signs of initial calm returning to the market. On Tuesday, to aid liquidity, the New York Fed cut the fee that bond dealers pay to borrow Treasuries, and the three-month bill yield climbed to 3.60%. Two-year and 10-year yields each fell five basis points, to 4.02% and 4.59%, respectively. T-bill yields increased again on Wednesday, as a calmer market tone continued. Two-year note yields surged 14 basis points to 4.16% amid speculation that the Fed will lower its benchmark rate by only 25 basis points at its next meeting.

Treasuries moved higher on Thursday following bearish comments from the CEO of Countrywide (NYSE: CFC  ) that the housing market could lead to a recession. While stocks slumped, the three-month yield climbed 28 basis points to 3.91%, and the two-year yield rose four basis points to 4.20%. On Friday, the short end of the curve continued to ease as liquidity improved. Home sales and durable-goods reports beat expectations and lessened the fears of an economic slowdown. The three-month bill yield tacked on 28 basis points, while the two-year yield added eight basis points and the 10-year yield gave back one basis point.

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

  • The U.S. Treasury announced that this week it will sell the largest amount of three-month T-bills in seven years and the largest amount of six-month bills in more than a year.
  • The U.S. Treasury sold $21 billion in three-month bills on Monday at 2.85%, the lowest rate in more than two years, and $17 billion in six-month bills at 3.95%. It also sold $32 billion in four-week bills on Tuesday, the largest amount in more than six years, to weak demand at 4.75%.
  • The Federal Reserve Bank of New York said it will redeem $5 billion of Treasury bills maturing last Thursday in order to give it greater flexibility to manage reserves.
  • Sen. Richard Shelby, R-Ala., said credit agencies shoulder some of the responsibility for the subprime mortgage crisis, because of their "inherent conflict" in helping structure the securities and then assigning ratings.
  • Accredited Home Lenders announced it will close most of its mortgage business and cut 62% of its work force.
  • Bank of America invested $2 billion in convertible preferred securities of Countrywide.
  • Bank of America, Citigroup, JPMorgan Chase, and Wachovia each borrowed $500 million through the Fed's discount window Wednesday.
  • Beazer Homes (NYSE: BZH  ) asked a federal court to prevent its bondholders from declaring it in default of its debt.
  • H&R Block tapped $850 million in credit lines because of difficulties selling its commercial paper.
  • Lehman announced it will close its subprime mortgage unit and incur a $25 million charge.
  • Moody's cut the ratings on $1.5 billion of securities comprised of 120 subprime mortgage-backed tranches.
  • Citigroup sold $1 billion in five-year notes.      
  • Comcast (Nasdaq: CMCSA  ) sold $3 billion of debt in a two-tranche offering of 10-year and 30-year securities.
  • Con Ed (NYSE: ED  ) sold $525 million of 30-year bonds, increased from $400 million.
  • Coventry Health Care sold $400 million in seven-year notes, increased from $300 million.
  • General Mills (NYSE: GIS  ) sold $700 million in five-year notes, increased from $500 million.
  • Goldman Sachs sold $2.5 billion in 10-year notes.
  • Merrill Lynch sold $2.75 billion in 10-year notes.
  • Morgan Stanley sold $1.5 billion in 10-year notes.
  • XTO Energy (NYSE: XTO  ) sold $1 billion of debt in a three-tranche offering consisting of five-, 10- and 30-year securities.

Hot tip
Over the last two weeks, the commercial-paper market (short-term debt issued mainly by financial and other large companies) has become the latest casualty in the widening credit crunch. According to a Fed report, the amount of paper outstanding dropped 4.2% to $2.04 trillion in the period from Aug. 15-Aug. 22, the largest decline in nearly seven years.

The difficulties accessing liquidity through commercial paper have been highlighted by the recent experiences of Countrywide, KKR Financial, H&R Block, Thornburg Mortgage (NYSE: TMA  ) , and cash management firm Sentinel, not to mention the recent difficulties in the Canadian commercial paper market. A run on three-month Treasury bills early last week displayed the market's search for safety and liquidity as investors shied away from commercial paper.

Commercial paper is very-short-term debt, maturing in less than 270 days, which is predominantly issued by financial and other large companies to raise money. Due to its short term, the paper typically pays low interest rates. One way to find higher returns in this asset class is to invest in collateralized debt obligation commercial paper, which often is backed by subprime debt.

That's where the problem could lurk for individual investors. While the usual $100,000 minimum investment in commercial paper bars individuals from owning any paper directly, money market funds represent significant commercial paper investors. In fact, money market funds totaling approximately $300 billion in assets have invested in subprime debt this year.

The $2.7 trillion invested in U.S. money market funds is typically thought of as residing in safe havens which provide returns somewhat better than bank savings accounts. Money market funds are managed so that share prices never rise above or fall below $1 for each dollar invested. The funds usually invest in Treasuries, certificates of deposit, as well as short-term commercial debt. Unlike savings accounts, money market funds don't carry federal insurance.

According to a report on Bloomberg, only once has a money market fund failed. In 1994, a fund managed by Community Bankers Mutual Fund was liquidated and paid investors 96 cents a share following a disastrous investment in adjustable-rate securities. Some think that fund companies would now step in to support the money market funds should they drop below $1 per share. These days, that's little comfort. Nor is the regulation that money market managers limit their investments to securities presenting "minimal credit risks." Money market investors should review their prospectuses to determine the extent to which their funds may be tied to the subprime fiasco.

Bank of America and JP Morgan Chase are Motley Fool Income Investor recommendations. 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 and Goldman Sachs, but none of the companies mentioned in this article. She prefers her portfolio shaken, not stirred. The Fool has a disclosure policy.


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