Thursday, March 25, 2010

What Happened in the Bond Market Yesterday?

Over the last few years we've learned that derivatives - loosely defined as instruments whose value derives from the prices of the underlying securities - can have an enormous impact on the capital markets.

Yesterday seems to have been one of those days. The Treasury bond market had its worst day in at least a couple of months, with prices falling across the maturity spectrum

There apparently were two reasons. First, the Treasury auctioned notes with a 5-year maturity and, unfortunately, demand was not particularly strong.

But the second reason was the one that interested me more. Apparently there were widespread "bets" placed on the idea that corporate bond spreads (i.e., the yield advantage of corporate bonds versus comparable Treasury securities) would be widening. However, this proved not to be the case, and in fact corporate yields in some cases moved lower than government bonds (see my post earlier this week).

So what happened yesterday? A number of traders threw in the towel, and sold their "long" Treasury positions covered their bets in the derivatives markets.

When you include the poorly-received Treasury auction, then, bonds got hit hard.

Here's an excerpt from this morning's Financial Times:

The negative swap time-warp

FT Alphaville has already noted on Wednesday how financial markets have breached new negative territory.

The 10-year US swap spread — the price to swap floating for fixed-rate payments — dipped below zero for the first time on record.

This is something that isn’t ever really supposed to happen, since it implies that it’s less risky to lend for 10 years to a money market counterparty than to the AAA-rated US.