Who Will Buy the Debt?

"Who will buy Treasuries when the Fed doesn’t?" is a question asked by major bond fund manager Bill Gross of PIMCO in his March 2011 Investment Outlook. Gross has come under considerable scrutiny for daring to divest his flagship Total Return bond fund of Treasury holdings post the late August QE2 announcement by the Fed/Bernanke, and in some timeframes thereafter apparently took short positions against Treasuries.

Despite the significant rally in Treasuries from mid-April, with a near 18%/10% decrease in the 10-yr/30-yr yields (leading to ~6-7% price appreciation on the market), Gross has essentially maintained his low-to-no position on Treasuries, with a 35% holding in cash equivalents, 21% mortgage debt, 18% high-grade corporate debt, and 20% equally split between emerging and developed market (mostly government) debt, shying away from municipal debt in a similar manner to Treasuries. Gross maintains he has "no regrets" over missing the recent Treasury rally, and recommends that bond investors should shift their weights to corporate or government debt issued by companies and sovereigns with far better balance sheets than the U.S. government (and also by implication, municipalities).

I submit the larger, more general question at this point should be: "Who will buy the debt?" Though debt-holders have continued (or have been forced) to de-lever from the credit market excesses that eclipsed in 2007/8, record debt issuance continues in the corporate markets and from the U.S. Treasury [1], thanks to historically low rates led by the Fed's zero interest rate policy (ZIRP) and ongoing permanent open market operations (POMO, or debt monetization).

Low yields mean investors may not be adequately compensated for the aggregate risks they are taking by buying the issued debt. Those risks include default, interest rate and inflation risks. The latter is already an issue: the real rate on the 5-yr Treasury note is currently negative [2]. Though default risks are in real terms lower for many high-grade corporates vs. our own sovereign debt, the current talk of sovereign default from Greece to the U.S. increases this risk span, yet rating agencies still rate Treasuries as AAA and the corporate-to-Treasury spreads are increasing as Treasuries rally. Interest rate risk (the risk that interest rates shoot significantly higher, sending bond prices sharply lower) is a real possibility that could lead to a broad market "event" not dissimilar to the Black Swan-type swoon we saw in 2008/9, except this time Treasuries may lack the "flight-to-quality" status that investors then sought for sanctuary while the stock, commodity, and non-government bond/debt markets all got pummeled. In this scenario, investors and traders may choose to dump some or all of their debt holdings (including Treasuries and munis), preferring not to get caught as prices fall, and therefore may trigger a cascade of selling and even sharper declines in prices.

As total outstanding debt continues to grow and yields are kept artificially suppressed, investors must ask why they should risk buying any debt if there is market volatility risk attached that could stem from default and/or interest rate risks. "Who will buy the debt" is the hazard for debt oversupply in any market, with markets increasingly correlated due to leverage and other factors.

[1] Total outstanding U.S. bond market debt as of Q1/2011 stands at some $35.5T, composed of $9.1T Treasury debt (26%), $7.6T corporate debt (22%), $8.5T mortgage debt (24%), $2.9T muni debt (8%), $2.9T money market debt (commercial paper, etc.)(8%), $2.5T federal agency debt (Fannie/Freddie, etc.)(7%), and $2T asset-backed debt (auto, credit card, home equity, student loan, etc.)(5%). The trend of this data since 2007 has clearly shown an increase of Treasury and corporate debt, and a leveling-out or decrease of all other types of debt, from the credit market deleveraging process. This data was sourced HERE from the Securities Industry and Financial Markets Assoc. (SIFMA). U.S. bond market debt is some ~39% of the total world-wide market debt estimated at ~$92T using Bank of International Settlements (BIS) data HERE. Note that these stats are total outstanding "market" or marketable/tradable debt, and not total outstanding market+non-market debt. I will discuss and source the latter in a future commentary, but the obvious example is the non-marketable U.S. Treasury debt that includes social security obligations, state and local government series bonds and savings bonds. 
[2] The U.S. Treasury has a nifty interactive yield curve flash app HERE, showing nominal vs. real rates and a historical rate comparison tool.

Failed Fed Auction an Early Warning?

Not widely reported except by Bloomberg, the Federal Reserve (Fed) had a rare failed auction last week of mortgage-backed securities (MBS) "purchased" by the Fed from AIG during its $182.5B bailout in 2008/9. The Fed bought a total of $52.5B of MBS from AIG as part of the bailout package, forming the "Maiden Lane II" portfolio of distressed crisis assets on its balance sheet. Why should investors and traders care about this event? Keep reading.

In a June 8 dutch auction, investors only bought $1.9B of $3.8B of debt offered, causing market spectators to question the quality of MBS assets that AIG dumped on the Fed (or that the Fed overpaid for). The byline is that the Fed ended up selling the assets into a weak(ening) market, a casualty of bad timing. The irony is that the Fed was offered $15.7B from the rescued-and-lingering AIG for repurchase of the remaining $31B Maiden Lane II portfolio in March. Perhaps the Fed saw such a discount repurchase (reverse repo, actually) as a giveaway that would get too much press attention as a taxpayer loss, and decided that selling into the open market was a more tenable option. Credit markets in February-March were at a 2-year "high" of health, but have since deteriorated somewhat, with both MBS and corporate high-yield (junk) debt spreads increasing along with the price of credit default swaps for major banks and bond insurers.

So why should investors and traders care about this event? First, failed Fed auctions are a rarity. Second, the Fed has some $2.8T of "crisis assets" on its balance sheet [1], with ~$2T collected since fall 2008. Yes, the majority of those assets are Treasuries bought via quantitative easing asset swaps, and are AAA-rated, of the very highest quality debt (for now). Likely, the Fed won't be unwinding its balance sheet anytime soon, given some show of recent economic weakness and calls for even more quantitative easing from some quarters. The questions that arise are: Is selling into a weak market a destabilizer for credit/debt markets, and what is the risk of more failed auctions as the perception of quality deteriorates? Could those failed auctions ever be mint-Treasury auctions by the Treasury [2], forcing the Fed to continue loading its balance sheet and monetizing debt? And then there's always the question of all that muni-debt...

Note I am not just another "chicken little" on the issue of failed auctions and bond market turmoil, as the quality of debt has always been, and always will be, the paramount concern. If the 2008 crisis taught us anything, an oversupply of debt in the market can have destabilizing consequences, especially if quality of that debt declines. Investors and traders need to be vigilant of any signs of worsening conditions.

[1] Public view of the Fed's balance sheet can be found HERE.
[2] Newly-issued Treasury auctions can be tracked HERE.