Oddity in bond market signals an economy on the mend

An unusual move in the fixed-income space last month is being interpreted as the latest bullish sign of economic recovery.
Beginning around mid-October, Treasury yields started rising while corporate bond yields, which usually move in tandem, pulled back a bit. The result was a narrowing of the spread between government and corporate paper to 2.04%, from 2.28% by the end of the month.
“This is a good thing because it’s a sign of credit market recovery,” said Robert Tipp, chief investment strategist for Prudential Fixed Income, a unit of Prudential Financial Inc.
On the Treasury side, much of the yield movement was attributed to the Federal Reserve’s plan to kick off a second round of quantitative easing by buying back at least $600 billion in government debt.
Market anticipation of the Nov. 3 Fed announcement was evident during the first week of October, when yields on 10-year Treasuries hit 2.38%, a new low for the year.
But by the end of October — still about a week before the actual quantitative easing announcement — those 10-year Treasury yields were back up to 2.72%.
Corporate bonds, meanwhile, saw median yields fall from 4.63% from the middle of October to 4.25% at the end of the month.
Bond market analysts see this kind of divergence between corporate and Treasury yields as significant. But it is not always easy to pinpoint the exact drivers behind the trends.
“Basically, what is curious is why spreads fell as quickly as they did,” said Chris Shayne, a director at BondDesk Group LLC.
One theory of what is driving down corporate bond yields, he said, is the strong institutional demand for company debt, which is largely coming from investors’ pouring money in to bond mutual funds.
Mr. Shayne described the yield spreads as a proxy for risk, and explained that lower corporate yields suggest that investors are less concerned about the ability of the corporations to pay back the loans.
“A wider spread means there’s more fear in the market, and right now it looks like people feel better about getting paid back,” he said.
As for the sudden spike in Treasury yields, Mr. Shayne said there are also possible explanations related to investor sentiment and market optimism.
After 10 consecutive weeks of watching yields on the 10-year Treasury decline, “people got nervous that it might have over-corrected,” he said.
The strength of the equity markets over the past few months also could have coaxed more investors toward riskier assets such as stocks and out of Treasuries, which has the effect of driving up Treasury yields, he said.
Another explanation, he added, might be the looming impact of the second round of quantitative easing by the Fed.
“People probably will want to get out of Treasuries with QE2 coming,” he said. “Inflation is terrible for bond holders.”