Yield inversion, tight spreads tell different tales

But a Citigroup strategist thinks tight spreads can't last forever

NEW YORK (MarketWatch) - The simultaneous appearance of an inverted yield curve and tight corporate bond spreads this year underscores the clash between fixed-income investors who believe the economy is headed for a recession and those who think it remains in good shape, Citigroup economists said Monday.

"There is a battle going on in the bond market," said Tobias Levkovich, a Citigroup managing director and chief U.S. market equity strategist. Levkovich appeared at a presentation on Citigroup's 2007 outlook in New York.

"If you think yield curve inversion equals a recession, the credit spreads tell you that this is not happening because spreads are getting narrower," he said.

The spread is the difference between the yield on a corporate bond and that of a comparable Treasury note. Tight spreads indicate confidence in the health of the issuing company. Tight spreads across the curve point to confidence in general corporate economic strength. Widening spreads reflect investor demand for a bigger return for taking on the extra risk of a less reliable issuer.

An inverted yield curve takes place when long-term debt instruments have a lower yield than short-term debt instruments of similar credit quality. An inverted yield curve also removes the motive for loaning money long-term.

On Monday the yield on the two-year Treasury note perched at 4.727%, above the 4.547% yield ($TNX : CBOE 10-Year Treasury Yield Index
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Last: 45.07-0.31-0.68%

11:09am 11/28/2006

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45.07, -0.31, -0.7%) on the 10-year note. The yield curve has been inverted at many points in 2006.
In the past inverted yield curves have been harbingers of recession, but a number of economists, including Federal Reserve Chairman Ben Bernanke, do not think this is the case in the present instance.
Bernanke, and his predecessor Alan Greenspan, have attributed the inverted yield curve to a "global savings glut" that has sparked fervid demand for Treasurys and U.S. corporate bonds. Economists have noted that this buying spree is inconsistent with the possibility of a looming recession.

Levkovich said today's phenomenon of curve inversion coupled with tighter spreads is the opposite of what occurred in the 1999-2000 period. At that time there was an inverted curve with wider spreads and that inversion heralded a recession.

Levkovich also predicted that tighter spreads are unlikely to persist for long because of this year's large spate of leveraged buyouts. To finance these deals many companies have turned to the capital markets to borrow money by issuing junk-rated bonds.

The strategist said that "sooner or later" some issuer will be forced into default. That should cause a reversal of confidence in corporate issuance and spreads then should widen, he predicted.

Leslie Wines is a reporter for MarketWatch in New York