Bloomberg News

Swaps on Treasuries Reach Record Versus Bunds in S&P Denial

September 06, 2011

(Updates prices, starting in the third paragraph.)

Sept. 6 (Bloomberg) -- U.S. debt rated AA+ is beating AAA German bunds as investors seek the safety of the world’s biggest bond market amid slowing growth and Europe’s financial crisis.

Traders are paying $73,830 a year to protect $10 million of Treasuries against default, less than during the height of the financial crisis in 2008 and below the $78,670 for higher-rated German bunds, according to CMA. The difference between prices of the credit-default swaps reached a record $17,370 on Aug. 29, even after Standard & Poor’s cut America’s credit rating.

Investors have determined Germany, the largest European economy, is riskier because of rising costs to bail out Greece, Portugal and Ireland. Money managers are also repudiating S&P’s Aug. 5 decision that Treasuries are worth less, driving them up 2.67 percent, against a 2.09 percent gain for bunds. U.S. government debt returned 2.8 percent in August, the most since December 2008, Bank of America Corp. indexes show. The yield on the U.S. 10-year note dropped to a record 1.9066 percent today.

“The growing storms and fears of the imminent debt restructuring in Europe is putting people into the deepest, most liquid market in the world and it’s the natural place to go,” said James Camp, managing director of fixed-income in St. Petersburg, Florida, at Eagle Asset Management Inc, which oversees $19.5 billion, in a telephone interview on Sept. 1.

The $14.6 trillion U.S. economy is more than four times the size of Germany’s $3.3 trillion, data compiled by Bloomberg show.

Bond Demand

Investors poured $78.4 billion into bond mutual funds this year as of July, according to data from Chicago-based Morningstar Inc. They snapped up Treasuries even as marketable U.S. debt outstanding grew to $9.38 trillion, equivalent to about 64 percent of gross domestic product, from $4.54 trillion in mid-2007, before the recession and collapse of Lehman Brothers Holdings Inc., according to data compiled by Bloomberg.

Prices of credit-default swaps tied to Treasuries have dropped to the lowest since May, and are down from more than $91,000 on July 28, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Rather than speculating that the U.S. will default, traders often use the contracts to hedge against losses in Treasuries, meaning that a decline indicates they see less of a chance of a sell-off in the bonds even with yields at about record lows.

Plunging Yields

Since S&P, a unit of New York-based McGraw-Hill Cos., cut the U.S. to AA+ from AAA, the yield on the 10-year Treasury note, a benchmark for everything from home mortgages to corporate bonds, plunged to a record low of 1.97 percent on Aug. 18 from a high this year of 3.77 percent. Moody’s Investors Service and Fitch Ratings affirmed their top rankings on the U.S.

“Rates have stayed lower than anyone had expected,” Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed- income officer for Fifth Third Asset Management, which oversees $22 billion, said in an interview last week. “The ten-year may go up to 2.5 percent, but it will not rise dramatically by year- end.”

Yields on 10-year Treasuries dropped 20 basis points, or 0.2 percentage point, last week to 1.99 percent as a government report showed U.S. employers added no new jobs in August and the unemployment rate was unchanged at 9.1 percent. The price of the benchmark 2.125 percent security maturing in August 2021 rose 1 25/32, or $17.81 per $1,000 face amount, to 101 6/32.

Strategists have cut their year-end forecast for the yield to 2.69 percent from 3.5 percent in July, according to the median of 58 estimates in a Bloomberg survey. The yield has averaged 5.1 percent since 1991.

Obama Jobs Plan

President Barack Obama will unveil plans to spur job creation in a speech to Congress Sept. 8. A supercommittee consisting of Democrats and Republicans has begun seeking $1.5 trillion in deficit cuts by the end of November.

S&P said Aug. 5 that the government is becoming “less stable, less effective and less predictable.” The firm said lawmakers failed to cut spending enough to trim record deficits and that it may lower the long-term rating to AA within the next two years if reductions are less than agreed to, interest rates rise or “new fiscal pressures” during the period result in higher general government debt.

Officials in Washington are now debating ways to cut spending, which may put a drag on the growth at the same time economists are already paring their forecasts. The median estimate of more than 56 economists surveyed by Bloomberg News is for gross domestic product to expand 1.75 percent this year. That’s down from 2.5 percent in a June poll.

‘Suicidal’ Move

Cutting spending “right now is almost suicidal,” said Bill Gross, who as co-chief investment officer at Newport Beach, California-based Pacific Investment Management Co. runs the world’s biggest bond fund. Gross made the comments in a radio interview on “Bloomberg Surveillance” with Tom Keene and Ken Prewitt after the Sept. 2 jobs report.

Market turmoil following S&P’s move erased about $2.3 trillion from the market value of U.S. equities since the Standard & Poor’s 500’s recent high on July 22. The MSCI All- Country World Index of stocks fell 7 percent last month, the biggest slump since May 2010.

“The downgrade by S&P may have caused a lot of angst,” Andy Richman, who oversees $10 billion as a strategist in Palm Beach, Florida, for SunTrust Bank’s private wealth management division, said in a telephone interview on Sept. 2. “It was a non-event as far as the credit strength of the U.S.”

Expensive Bonds

While Treasuries may not tumble, some market measures suggest that there’s little room to rally further. A financial model created by economists at the Fed that includes expectations for interest rates, growth and inflation indicates 10-year notes are near the most overvalued levels on record.

The term premium, which Fed Chairman Ben S. Bernanke cited in a 2006 speech in New York as a useful guide in setting monetary policy, fell to negative 0.46 percent Sept. 1, indicating the notes are expensive when compared with the average 0.84 percent for the gauge this decade through mid-2007.

“We are in the camp that growth will be south of 2 percent for remainder of the year, but that would put gentle upward pressure on rates,” Stapley said.

Unlike in the U.S., Europe’s bond market shows rising pressure on lawmakers to cut budget deficits as the region’s debt crisis threatens to spread to Italy and Spain from Greece, Ireland and Portugal, which had their ratings cut to below investment grade.

Europe Swaps

The Markit iTraxx SovX Western Europe Index of credit- default swaps insuring the debt of 15 governments rose to a record 310 in London on Sept. 2, surpassing an all-time high closing price of 308 on Aug. 26. The index has climbed from this year’s low of 157.4 in April.

Austerity measures in Europe mean the euro area’s GDP may grow 1.4 percent next year, down from 1.8 percent in 2011 and compared with 2.35 percent in the U.S., according to the median estimate of 19 economists surveyed by Bloomberg.

Credit-default swaps on 10-year German bunds climbed to a record of 86.9 basis points on Aug. 11. Contracts on 10-year Treasuries are down from an all-time high of 100 in February 2009 during the depths of the financial crisis.

The difference between swaps on bunds and Treasuries touched a record 38.6 basis points on Aug. 29. Contracts on bunds have typically cost about 3 basis points less than U.S. debt since 2007. As recently as May the gap was 12.5 basis points in favor of Germany.

‘Muddied Waters’

“Germany is starting to be muddied by the waters of its European colleagues,” David Keeble, head of interest-rate strategy at Credit Agricole Corporate & Investment Bank in New York, said in a telephone interview on Aug. 31.

German Chancellor Angela Merkel reiterated Aug. 19 her opposition to jointly sold bonds by the euro area’s 17 nations to stem debt concerns. Germany would face extra costs of 47 billion euros ($66 billion) a year through the alignment of interest rates with nations that pay more to borrow, the country’s Ifo institute said on Aug. 17.

German Elections

Merkel’s party suffered its fifth election loss this year on Sept. 4 as the Social Democrats, the main opposition party nationally, took 35.7 percent to win election in Mecklenburg- Western Pomerania, preliminary results show. Merkel’s Christian Democratic Union had 23.1 percent. The result means her national coalition has been defeated or lost votes in all six German state elections so far this year as voters resist her bid to prevent a euro-region breakup by putting more taxpayer money on the line for bailouts.

So far the rescue bill includes 365 billion euros in official loans to Greece, Portugal and Ireland, the creation of a 440 billion euro rescue fund and 96 billion euros in bond buying by the European Central Bank.

“The market is treating Germany as if it’s going to be part of a bigger fiscal union to provide guarantees for Spanish and Greek debt,” Keeble said. “We have a lot of safe-haven players in Treasuries that think the world could collapse into a great big black hole.”

--With assistance from Anchalee Worrachate in London. Editors: Philip Revzin, Dave Liedtka

To contact the reporter on this story: Susanne Walker in New York at swalker33@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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