Treasury selloff stymies shorter corporate debt

NEW YORK (Reuters) - A shift in bond market bets toward the U.S. Federal Reserve hiking interest rates by year end has sent short-dated Treasury yields higher, eroding much of the premium corporate bonds offer and giving some fund managers pause.

After a stellar six-month corporate bond rally, government bonds' latest move is making some shorter maturity corporates seem expensive, they said.

As a result, the rally in shorter-dated corporate bonds is faltering as fund managers park some money in cash and wait to see if prices surrender some of the gains posted since the market hit a record low in December.

"Those spreads are very, very narrow," said William Larkin, portfolio manager with Cabot Money Management in Boston.

Expectations of a future bout of inflation have added to demand for shorter maturities, with many investors shying away from 7-year maturities or longer, which are especially vulnerable to inflation pressures, he said.

INFLATION THREAT

"As expectations of inflation rise, that puts me in a pickle right now because everything starts to get expensive," Larkin said.

Illustrating the trend, on Tuesday, Wal-Mart's (WMT.N) 4.50 percent issue due in 2015 traded at 20 basis points over Treasuries for a yield of 4.05 percent, from 102 basis points spread and a yield of 3.69 percent on April 1, according to MarketAxess.

One worry is that the rise in Treasury yields, if sustained, could nip a nascent economic recovery in the bud, curbing corporate profits and weighing on company debt prices.

Earlier this week, the 2-year Treasury's yield, which moves inversely to its price, was up some 44 basis points in just two trading sessions. The jump to 1.40 percent came after Friday's better-than-expected U.S. jobs report, which created big losses for those holding shorter-dated government notes.

Such a shift makes corporate bonds look pricey. Even so, many strategists expect current expectations the Fed may hike rates by year end to fade and for Treasury yields to slip somewhat, restoring a bigger premium for corporate bonds.

"For a corporate buyer in the 2-year and 3-year area optically this has the effect of making spreads look tighter," said Alex Roever, short-term fixed-income strategist with J.P. Morgan Securities in New York.

However, "even if we are ending recession, growth will be slow and there is not likely to be inflation," he said. The Fed may not start raising its benchmark short-term lending rate, currently in a band between zero and 0.25 percent, until 2011, he said.

"It is hard to argue that these Treasury yields are at the right level. Probably they need to retrace some," he said, "in which case I think it makes the corporate credits not look substantially worse."

U.S. investment grade bonds' yield spreads over Treasuries have narrowed to 352 basis points as of Monday according to Merrill Lynch data, from 600 basis points in mid-March when the Fed said it would buy $300 billion of Treasuries over six months in an attempt to hold down government bond yields.

But Treasury yields have risen steeply since.

Now, shorter maturity corporate debt prices may be at an inflection point, said Larkin, who is putting some money in cash. Larkin is also considering buying longer-dated notes and bonds, betting that a much feared surge of inflation does not happen for some time.

Yet analysts remain deeply concerned that huge government debt issuance to pay for financial rescues, expected to run to about $2 trillion this fiscal year alone, may ultimately trigger malign inflation. That could force the Fed to raise interest rates sharply and risk stifling economic activity.

The narrowing of corporate bond spreads "is rational," said Jay Mueller, senior portfolio manager with Wells Capital Management, Milwaukee, Wisconsin. "If the economy is coming out of recession; people buy riskier assets." However, Mueller cautioned: "it is also the issue of supply. The Treasury is bringing auction after auction."

(Editing by James Dalgleish)