WSJ -- Bond Dealers, Traders Say 'Ouch'.
August 3, 2003
Bond Dealers, Traders Say 'Ouch'
Investors Unwind Positions As Interest-Rate Bets Sour
By AGNES T. CRANE
DOW JONES NEWSWIRES
NEW YORK -- So long easy money, hello pain.
Bond dealers, hedge funds and others lulled into trades based on the assumption that low yields were here to stay broke out the baseball bats last week to beat their way out of highly leveraged bets. In the process, they hammered Treasury yields to levels not seen since last summer, while also battering agencies and other market sectors.
Selling reached a fever pitch by Thursday, as mortgage investors, who earlier had helped accelerate the pace of the market's bull run, stampeded toward a narrow exit.
"I can't remember a day like [Thursday]," said J.P. Marra, head of government bond trading at Lehman Brothers and a 13-year market veteran. He says believes the impact will be far-reaching, affecting dealers, hedge funds and anyone else who had moved heavily into fixed-income market positions expecting bond yields to remain more stable.
Some of the bloodletting abated Friday, as Treasurys ended mixed after a weaker-than-forecast Labor Department report on July payrolls.
At 4 p.m., the benchmark 10-year note was up 3/32 point, or 94 cents per $1,000 face value, at 93 25/32. Its yield fell to 4.415% from 4.427% Thursday, which was a new high for the year. The 30-year bond's price was up 26/32 point at 100 22/32 to yield 5.328% down from 5.384% Thursday.
Still, the reversal from bull to bear market may be felt for some time, although its full impact still isn't clear.
Michael Krauss, chief technical strategist at J.P. Morgan, recalls large moves in yields after the 1987 stock crash and in 1994, when the Fed surprised the market by raising short-term rates. Similar to then, the speed of the move is more of a problem than actual market levels, he said.
This spring, investors bet big that rates would remain near historic lows for some time, largely because of warnings by Federal Reserve officials that the risk of deflation, though remote, could derail the recovery.
Those investors reckoned that could mean only one thing: that the Fed would buy long-term Treasurys to combat falling prices. So they leveraged up, aiming for easy and healthy returns through so-called "carry trades." They borrowed at low yields and then went "long," or bought bonds ranging from Treasurys to mortgage issues.
But many investors were disappointed in late June when the Fed cut rates by a quarter percentage point instead of a hoped-for half point. Thus began the "great trade unwind" of 2003, as leveraged investors began to bail out of what had been a very compelling trade.
When the 10-year note reached 4% in late July, selling became vicious as rising yields forced holders of mortgage-backed bonds to sell Treasurys and other fixed-income securities aggressively to rebalance portfolios.
"Everyone who's long interest rates has been hurt," said Alan Kral, a funds manager at Trevor Stewart Burton & Jacobsen, New York. "You're going to see negative performance unless you were in cash."
Other Market Activity
Last week's Treasurys selloff continued to take a toll on the high-yield, or junk, bond new-issue market.
Dynegy was able to boost the size of a secured, second-priority deal to $1.45 billion from $1.325 billion, but some of the notes will yield about 0.25 percentage point more over Treasurys than the high end of an indicated range.
A $525 million, seven-year portion will yield 10%, and a $700 million, 10-year maturity will yield 10.25%. An additional $225 million of five-year floating-rate notes will pay the six-month London Interbank Offered Rate, or Libor, plus 6.50 percentage points, according to people familiar with the offering.
Indications had been for a yields of: 9.5% to 9.75% for the seven-year notes; 9.75% to 10% for the 10-year notes; and six to 6.25 percentage points over Libor for the floating-rate part. Credit Suisse First Boston was sole bookrunner.
Dynegy's $175 million 20-year convertible subordinated notes, sold Friday via CSFB and Morgan Stanley, will have 4.75% coupon, up from an earlier indicated 3.25% to 3.75%. Rising Treasury yields were largely to blame, along with heavy high-yield new-issue volume recently.
Separately, Graphic Packaging International Inc.'s $850 million deal was set to yield 0.50 percentage point above the wide end of pricing indications. Its $425 million of eight-year senior notes will pay an 8.5% coupon, while $425 million of 10-year senior subordinated notes will pay 9.5%. Goldman Sachs, Deutsche Bank, J.P. Morgan, Morgan Stanley, CSFB and Citigroup were joint bookrunners.
Meanwhile, investment-grade corporate bonds were sent reeling by a sharp widening in interest-rate swap spreads.
The bank and finance sectors were particularly hard hit. J.P. Morgan's 10-year debt was quoted at a margin of 1.11 percentage points over Treasurys, up from an early level of 1.01 percentage points, according to MarketAxess.
Indications that the economy is improving normally would cause yield margins to narrow. But because investors have to factor in the additional credit risk of corporate bonds compared with those of swaps and agencies, an increase in the yield premium in those markets spills through to corporate issues.
"On a relative value basis, corporate spreads need to widen," said James Prusko, senior portfolio manager at Putnam Investments in Boston.
---- Tom Barkley and Christine Richard
Write to Agnes T. Crane at agnes.crane@dowjones.com
Updated August 3, 2003 7:10 p.m.
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