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If the U.S. bond market isn’t as safe as you’ve been told, how would you know? How can you actually measure how close we are to the day of gloom and doom and $8,000 gold? You’d begin to have an idea that the world was going to hell in a hand-basket if you could measure the spread between U.S. debt (which WE know to be risky) and debt that the market considers risky, namely baseline emerging market debt (BED). A BED spread, you say? Ask... and you shall receive. The BED spread (or BS as it’s been called by a few readers) is the proprietary indicator I developed to keep track of how close the U.S. government is to losing its reputation for credit worthiness. To get it, I established a spread between emerging market debt and U.S. government debt. If I’m right about the U.S. bond market losing its gold-standard reputation, the spread should converge over time. U.S. government bond yields will rise as the dollar falls. And emerging market debt yields will fall as it becomes comparatively less risky than dollar-denominated debt. You COULD come up with an indicator by comparing the 10-year Treasury note with, say, an equivalent Argentine or Russian government note. But I prefer to take a broader measure of emerging market debt versus U.S. government debt. I picked two closed-end bond funds, GVT and EMD. 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%
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%
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).
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,
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.”
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