GVT is the Morgan Stanley Government Income Trust. One hundred percent of the fund's assets are dollar denominated. When I first calculated the BED spread, about three weeks ago, GVTt currently yielded 4.18%. That was higher than the yield on the 10-year note at the time  (4.04%.) But GVT is an excellent proxy for the market's general perception of the creditworthiness of the U.S. government because it’s a “basket” of government bonds. Here are its top five holdings and allocations: 

1. U.S. Treasuries 30.28% 
2. Short-term bonds 27.99% 
3. Fannie Mae bonds 23.02% 
4. Freddie Mac bonds 11.96% 
5. Ginnie Mae bonds 6.75% 

To represent the other side of the spread,  emerging market debt, look at EMD, the Salomon Brothers Emerging Market bond index. Eighty-eight percent of the fund's holdings are in sovereign (government) debt. While not absolute, you’re basically comparing apples to apples…the bonds of emerging market governments versus Uncle Sam's bonds. Here is how EMD's top five holdings are allocated: 

1. Brazil 23.57% 
2. Mexico 20.87% 
3. Russia 17.97% 
4. Colombia 5.08% 
5. Ecuador 5.05% 

When I first calculated the BED spread, EMD yielded 9.76%. So about three weeks ago, the BED spread was 5.58%. Based on the wide spread, the market did NOT perceive a great deal of risk in U.S. government debt. But that would soon change…

The second time I calculated the BED spread, the yield on EMD fell to 9.59%, while GVT's yield was up to 4.22%. In bond speak, that means bond prices are up for EMD and down for DVT (yields and prices move in the opposite direction).

The new BED spread was 5.37%. Convergence approacheth. And it's precisely what you'd expect given the news in the bond market that week.  Why? 

First, Moody's Investors Service upgraded the rating on Russia's foreign-currency bonds by two levels. Russia's Eurobonds were upgraded to Baa3--the lowest investment grade level--from Ba2. Specifically,  Russia's 5% dollar bond due in 2030 gained 2.65 cents on the dollar in one day. 

That particular bond is the most traded emerging market Eurobond. And it was bound to help EMD. While 17% of the fund's total assets are in Russian debt, its single largest holding is $7.7 million worth of Russian government bonds -- about 10% of its total portfolio. 

Second, emerging market debt yields are converging with U.S. Treasury yields because what's good for Russia is turning out to be good for other emerging market bonds, including Brazil. Brazil's 8% bond due in 2014, which is THE MOST widely traded emerging market bond, rose that week too, as yields fell. Brazilian bonds constitute 23.5% of EMD's portfolio, and four of its 10 largest particular holdings. 

On the other side of the spread, the U.S. government side, there was trouble in agency security land. Agency securities are otherwise known as the mortgage-backed bonds issued by Freddie Mac and Fannie Mae. And like a dream it can't wake up from, the market is slowly recognizing how many bad credit risks Freddie and Fannie have taken...and how this directly implicates the creditworthiness of the U.S. government, whose implied guarantee of agency debt made it possible for Freddie and Fannie to get so overextended in the first place. 

The problem reared its ugly head in Atlanta and Pittsburgh a week ago. Federal Home Loan Banks in both cities reported losses of $9 million and $7 million, respectively, for the third quarter. Both banks claimed the losses came from low mortgage rates "pinching off" interest income on their derivatives holdings.

Perverse, isn't it? It's those same low interest rates that have kept mortgage issuance and refinancing activity so high. Yet even what's been historically good for the mortgage lenders is now turning out to be a problem. 

Granted, $9 million and $7 million losses won't break the bank. But the $200 million loss reported by the New York FHLB last month gets closer to breakage. THAT loss was chalked up to bad investments. And that brings us to the heart of the issue, with agency debt in particular and U.S. government debt in general. 

Freddie and Fannie have been issuing mortgage-backed debt at a ferocious pace in the era of historically low mortgage rates. It's dangerous risk-taking predicated on the ability of new homeowners to pay off mortgages AND the appetite of bond investors for mortgage backed securities. Yet that's exactly the kind of investment that went bad in New York. And that's the investment that will likely go bad all over the country. 

To keep expanding, the housing boom must attract more and more buyers. The voracious need for new buyers forces Freddie and Fannie to lend to riskier borrowers. To keep the boom going, the market extends more and more generous offers to less and less qualified buyers.

Eventually, Fannie and Freddie will be on the hook in two ways. They will have made loans to homeowners who can't pay. And they will have packages up those loans and sold them as bonds to bondholders who, will, I’m guessing, demand payment. 

Who will pay the bondholders when the homeowners default? The U.S. government? Santa Claus? The Daily Reckoning Paris office? You? 

The U.S. government ALREADY has its hands full paying its own sovereign debt not to mention Social Security, Medicare, and Medicaid  GVT, which has 30% of its holdings in Treasuries and 35% in agencies -- is a great proxy for the credit problems of the U.S. government. 

We saw it again this week as the Treasury department reported a $374 billion deficit for the fiscal year ended in September. That number was better than the White House predicted back in July. But it’s not exactly good. And it wasn’t exactly good for the BED spread.

As of this writing, EMD yields 9.50% and GVT yields 4.24% for a spread of 5.26. That’s three weeks in a row of convergence…from 5.58 to 5.37 to 5.26.

The spread would be even larger if Treasuries still didn’t enjoy their reputation as safe havens. Yields on the 10-year note climbed as high as 4.46% before stocks retreated when the Conference Board reported that the leading economic indicators fell in September.

And who knows after all? I could be completely wrong. Perhaps 10-year notes wont rise much beyond 5%, if that. But I suspect otherwise. I suspect there is looming chaos in the bond market, spawned by Fannie, Freddie, and the simple belief that U.S. bonds will always be accepted as safe and dependable. 

If you believe that, I’d like to introduce you to my big fat friend in his bright red suit.

Warm regards,

Dan Denning,
for The Daily Reckoning

P.S. EMD and GVT are not perfectly representative of the yields on the underlying bonds in their respective portfolios. This is a function of how closed-end funds calculate yield. But in general, the BED spread gives you a pretty solid way to measure the big-picture perception of creditworthiness in the market. 

And it’s also an excellent indicator for when to try and make money by “selling the dollar.”

Dan Denning is the managing editor of Strategic Investment. He is currently researching the calamitous effects a correction of the U.S.'s "twin deficits" would have on the economy. To learn more see Dan's report: 

http://www.agora-inc.com/reports/DRI/HungarianA/