Is Yield Curve Signalling a Downgrade Risk?

Is Yield Curve Signalling a Downgrade Risk?

There are many types of bonds ranging from those issued by Government treasuries, municipal departments to corporations. In simple definition, bonds are IOUs that strike a lending agreement between two parties based on the mutually agreed interest repayment to be paid periodically until upon maturity-term. Otherwise, zero-coupon bonds are those sold below face value but can be redeemed at full maturity-term with a one-time repayment of compound interest.

Generally speaking, long-term bonds pay higher yields than short-term bonds owing to flexibility of tenure by the borrowers. However, there are times when these two periodic yields go vice-versa and form an Inverted Yield Curve. Unfortunately, such situation is interpreted as ominous sign when it emerges in treasury-debt markets. When the yields of these 2-year bonds and 10-year bonds turned flat during the financial crisis period in Y2007 – 2008, the yield curve signalled recession that investors were unwilling to lock in their funds for a decade and also adopting an observation to monitor the U.S. Government’s resolution in managing the crisis!

With the increment of money supply by the Obama administration, inflation has been ballooning in post-crisis period. In contrary to the situation that we mentioned above, the yield differentials of U.S. treasury bonds have been running up steeply. From our recent observation, it shows many U.S. economy data have are pointing to gradual inflation within the economy and thus, interest rates are rising rapidly in the yields of long-term bonds.

In early February, the 1-year yield of U.S. treasury bonds traded at 0.74 percent while the 10-year yield climbed to above 3.6 percent. Investors are worried of an imminent runaway inflation if FED continues to pump in funds to support Government’s bonds prices as rescue stimulus. As a result, many bond experts believe the bloated budget deficit with no clear plans to reduce debt would jeopardize its AAA-rating of U.S. debt instruments and eventually lead to a downgrade.

Head of U.S. rate strategy at Bank of America Merrill Lynch commented that we have never seen these moves when we have had better economic data in the past with Fed rate hikes on the way.  From current outlook, the yield curve is flashing “concerns about an unsustainable fiscal deficit and an eventual potential ratings downgrade”.

Some investors are starting to demand higher rates of return for holding longer-maturity Treasuries to compensate them for the risk that U.S. sovereign debt could be downgraded. The consequences of a U.S. credit-ratings downgrade could devastate the economy, pushing up borrowing costs and threatening the Dollar. The concern of a downgrade is likely to grow over the upcoming years if U.S. Government is unable to find a solution to reduce its external debts and federal deficits.

At current rate, the U.S. has incurred an external debt USD13.98 trillion as of June 2010 and public debt estimated at 60 plus percent of national GDP about USD14 trillion in Y2010. In our opinions, the U.S. Government is stuck in a stagflation consisting of raising inflation but subdued growth. As FED might inject more liquidity into bonds markets, ballooning deficits are causing fear among investors of downgrades in credit ratings. If the housing mortgage rates go up to higher above 6 percent by trailing the long-term bonds yield, housing markets will deteriorate and hard to recover from the crisis slump!

For instance, Japan was stripped of its AAA status by Moody’s in 1998 and Standard & Poor’s in 2002 and downgraded to AA rating. On 27 January, Standard & Poor’s (S&P) cut Japan’s long-term sovereign debt rating by one notch to AA- again and signalled risk in investing with Japan’s long-term sovereign debt. However, Japan’s bonds market reacted calmly. With its federal deficits about 200 percent of GDP, the fatigue economy does not qualify to sustain higher yields but the near-zero short-term rates has put Japan in recession for many years.

In month of January, both Moody’s and S&P warned that the U.S. could be downgraded if it does not make progress in shrinking the debt level in next two years. Will U.S. economy mimics Japan into a financial decade if it does not contain the federal deficits in this new decade?

Observe the yield curve and find out the answer in these coming years.

Henry Seet is a protégé and certified coaching master of DAR Wong. The expressions expressed are solely theirs. They can be reached at www.traderpromaster.com