Year End Headaches Made Worse By Y2K

High yield participants, along with the rest of the fixed income world, have more year-end worries than just a shortage of short-term maturities resulting from cash outflows. Fixed-income professionals who are staring off at the horizon, waiting to assess how the Year 2000 will affect their market in the second half, may be missing the effect Y2K is already having on bond prices in the here and now.

While many bond pros shook off Y2K as a possible driving force behind recent price declines in the corporate bond market, some investors apparently began bracing for potential late-year disruptions as early as last month. In fact, a recent survey conducted by Merrill Lynch & Co. reveals that a full 44% of corporate bond investors polled began building liquidity in their portfolios in June in preparation for Y2K.

"There's some disconnect between the collective market belief about Y2K and what individual investors are actually doing," said Mary Rooney, fixed-income strategist at Merrill Lynch. "Many portfolio managers are quite concerned about Y2K, but think that their peers are not."

And in addition to those specialized concerns stemming from Y2K, high yield players are also fretting about possible retail outflows from the mutual funds that drive much of the sector's demand. In the commercial paper market, supply of paper maturing in the fourth quarter or early 2000 has already become nearly impossible to find, causing headaches for some short-term investors. In addition, many investors in money markets and in mortgage and asset-backed securities have already experienced some liquidity problems, according to Merrill researchers.

There's little doubt that jitters about Y2K fallout have contributed in large part to the recent surge in demand for short-term Treasurys. But less clear is the extent to which millennium fears played a role in the quiet but strong selling that emerged in the corporate bond market toward the end of the first half.

Of course, it's always extremely difficult to isolate any one factor when it comes to determining the cause of price movements in the corporate bond market. A variety of factors, including the Federal Reserve's rate hike and changes to popular fixed-income indices, doubtless influenced investor strategy in the second quarter. And as late as the end of June, most bond syndicate pros were still convinced that, outside of a pick-up in supply from issuers anxious to get their funding needs met early, Y2K concerns had not played a major role in market direction so far in 1999.

But the Merrill survey and conversations with fixed-income portfolio managers tell another story: At least some of the bid lists that have emerged in past weeks have come from investors selling corporate bonds to bulk up on more liquid assets prior to year end. Since many investors will seek to limit their credit exposure by selling off some corporate holdings rather than by hedging, the question for certain portfolio managers has simply become one of timing. "We think that spreads will be wider in the third quarter than they are now," said one portfolio manager who has begun to move into Treasurys.

Second-Half Storms

Potential for year-end chaos is nothing new to fixed-income investors. After weathering second-half storms for the past two years, many portfolio managers say that their top priority now is not to get caught off guard this time around. In the minds of many of these investors, Y2K is merely another reason to approach the second half with caution. "Most money managers had an excellent first quarter and a decent second quarter with regard to spread product," said Tracy Eccles, a senior vice president and portfolio manager at Hartford Investment Management Co.

In the corporate market, investors expect to see spreads in the fourth quarter widen by at least five basis points, according to the Merrill survey. Specifically, the 118 respondents said that they expect spreads on bonds issued by companies who experience Y2K-related problems to expand by at least 10 basis points.

Some investors are gearing their second-half strategies around just such an event. Most portfolio managers think that any Y2K disruption will be a relatively shallow and isolated event. If that's true, they believe that investors with liquid assets or cash to spend will have an excellent opportunity to pick up bargains if overall liquidity dries up and spreads widen.

But Eccles notes that in the current market environment, such bottom feeding might not be as easy as it sounds. She points out that in last year's liquidity crisis, disparities in broker-dealer bid-ask spreads made it impossible to buy a bond at anywhere near the same price you could sell one.

- Jeffrey Keegan