Increase in Treasury Issues Could Boost Yields
February 17, 2003
With investors' interest in bonds at record highs, it's worth noting that several factors are bearing on the bond market right now - heightened concerns over geopolitical risks, anticipated increases in U.S. debt, private de-leveraging and a decline in the U.S. dollar, among them.
Perhaps more significantly, President Bush's fiscal stimulus package and its effect upon the national debt not only have held the market's attention, but also, in fact, have sometimes rivaled the uncertainties about war against Iraq.
While the stimulus package about the preferential treatment of dividend income has made headlines, we here at Lipper believe it will merely have a modest impact on bonds, albeit not uniform. We expect the impact to potentially be greatest on longer-dated maturities and tax-exempts.
More Treasury Float
An increased issuance in Treasury issues, due to larger deficits, could drive yields higher and, hence, prompt a tightening in credit spreads for agencies, corporates and mortgages.
And any announcements by the Treasury about changes to the current financing mix - such as the announced increase in the number of five-year sales - will have an effect on portfolio strategies that are barbelled as either over- or underweight the short or intermediate part of the yield curve.
To deal with the last point first, the bond market is already voting on the announced changes to the financing mix in Treasury issuance. As several analysts have noted, in anticipation of a potential increase in the inventory of Treasuries, the "belly" of the intermediate sector of the Treasury yield curve, that is, bonds with three- and five-year maturities, have under-performed the two-year and 10-year tenors during the past 2 weeks.
As an example, through Feb. 5, 10-year yields dropped by 3.5 basis points versus the prior Wednesday, while five-year yields dropped just 0.2% of a basis point. A similar phenomenon existed for the two-year versus three-year tenors.
Bond funds following a barbell strategy stand to benefit from any continued moves in this direction. Furthermore, funds that are underweight the belly of the curve could benefit, as well.
As to crowding out, that is, yields being driven higher by an increase in Treasury debt issuance, we view this as having a less than significant impact on fund returns in 2003.
We hold this view primarily because we are expecting a modest U.S. recovery, which means subdued new issuance during the year and, with private de-leveraging expected to continue during 2003, an increase in the government's debt to $300 billion should be digestible.
The out years are another question. If the government's deficit continues for several years or the perception is that deficits will continue for as far as the eye can see, then crowding out has a better chance of occurring, especially if the U.S. trade deficit remains at it current level.
As to the centerpiece of the President's stimulus plan, the elimination of taxes on dividends, we've seen the muni market already reacting with many muni bond funds experiencing negative returns in January. While headline risk from state and local budget woes certainly had an impact on January's returns, we believe "dividend overhang" certainly played a role during the month.
As noted above, we expect the President's proposal to have a modest effect upon yields. Any "announcement effect" that occurred in January could be partially unwound as investors consider the dividend provision and the media provides commentary.
What we view as a more significant impact on munis, and possibly taxable long-term yields, is the excludable dividend amount (EDA) provision in the President's proposal. EDA tends to affect corporate buyers of debt, and corporate buyers of debt are primary suppliers of liquidity to the bond markets.
If the EDA provision is not changed from the President's proposal, corporate demand for munis could turn negative, and, over the long run, to quote a recent Salomon Smith Barney article, "the cost to issuers from this provision alone could be significant."
Andrew Clark is a senior research analyst at Lipper specializing in fixed-income mutual funds, asset allocation, quantitative research and Lipper Leaders. Prior to joining Lipper in 2000, Clark held senior positions at Citigroup in financial reporting, risk management and bond trading.
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