November 27, 2007
What a session yesterday was. Risk free bonds continued their path higher, but instead of marching it was an all out sprint.
30 year treasuries were up 3.5 dollars at one point during the day (that's 20 bps) and even more impressive was the 2 year treasury which had a 28 bp move!
Canada lagged in the size of the moves, but they were large as well, the Canada 30 year trading up over a point.
Once again, this came mostly at the expense of credit in the market. Corporate spreads moved wider once again as investors fled anything risky. This is leaving especially the financials in poor shape.
Take Lehman and Merrill ten year bonds as an example. Having traded as expensive as 104 bps over treasuries 6 months ago, these have gotten as wide as 280 bps over and are currently bid around +245 (chart example in Daily FI Snapshot). While risk free yields have declined significantly in 6 months, the cost of corporate funding has actually increased for even the safest corporations. This is worrying as it raises the prospect that Fed and Bank of Canada rate cuts won't have their desired effect should that lower cost of funds not work its way into the broader economy.
If you want this in terms that are much closer to home - the last time Canada bonds were trading this low in yield, a 5 year closed mortgage from ING direct in Canada could be gotten for about 5.00% (and rates were on their way up). Today that rate is 6% (while rates are coming down) - so while overall benchmark interest rates are lower, loans carrying risk are MUCH higher.
It's interesting to note that the credit yield spreads have not improved since the Abu Dhabi - Citigroup news. On first analysis, we'd argue this is because the Abu Dhabi deal should actually serve to WIDEN credit spreads. This isn't all good news. Abu Dhabi will be paid 11% yield on preferred shares for an average of 3.5 years until they are forced to convert to common shares. Given that market traded prefs are trading closer to 6.5% (lower in Canada), this seems like extraordinarily expensive financing for Citi, or the deal of the century for Abu Dhabi. Citi shares would have to fall by over a third in the next three years (and stay below that level) for Abu Dhabi to lose money on this deal. With Citi practically giving away this 4.9% stake in their company, we're worried about their underlying need for financing being much larger than the market anticipated, and more importantly, the implications of this on corporations who are not as big or stable as the Citigroup (which is ALL financials, as Citi is the biggest bank in the world)
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