Morgan Gets Paper-Thin Yield on Notes

Exploiting an aberration in the market for two-year Treasury securities, Morgan Guaranty Trust Co. recently issued $200 million of notes at the slimmest of yield premiums.

Morgan's two-year notes were priced at a discount to yield 6.85%, or 20 basis points over Treasury securities issued May 31. But the comparison was misleading because the yield on the new Treasuries was an artificially low 6.65%.

Compared with the prevailing rates for outstanding Treasuries due in two years, ranging from 6.71% to 6.75%, Morgan did far better than most investors believed. The notes, handled by Merrill Lynch & Co., carried a 6.75% coupon.

Managements usually dislike short sellers because they drive down stock and bond prices. But in this case, they inadvertently helped Morgan to strike an attractive deal.

Avenue to an Uptick

These short sellers got caught in a rare squeeze when they could no fulfill commitments to deliver new notes to investors. Other investors stepped in first and snapped up most of the notes, causing an uptick in demand.

Rising demand drove the price up and the yield down, out of sync with prevailing yields. That allowed astute borrowers to issue at low rates - by using the low yield on the new notes as a benchmark.

A source at Merrill said a number of other banks issued two-year notes at the same time, through unpublicized medium-term note programs.

"The spread between two and three year Treasuries had gotten as wide as plus 50 [basis points]," the Merrill source said. That was an indication that the two-year note was abnormally low, he said.

|Good Market Timing'

The same day, Deutsche Bank issued $100 million in two-year notes with a 6.875% coupon, at a yield to maturity of 6.9%.

"It was just good market timing," said William Downes, a vice president at Keefe, Bruyette & Woods.

Rumors persist that Merrill has had trouble distributing the issue. The Merrill source said the deals didn't sell out immediately "because the market turned against us." But he said that they were sold within a couple of days.

While short squeezes in stocks are fairly common, short squeezes in the Treasury market are rare.

Interest rates had gotten so low that many traders speculated that a new supply of two-year notes on May 22 could only depress prices and drive up yields. Anticipating this, a larger-than-average number shorted the notes.

This time, however, with most of the supply of two-year notes in only a few hands, the shorts could not borrow the notes they needed. To make good on their agreements with investors, which they had to do by May 30, they were forced to buy them instead.

Buying frenzy drove up prices and drove down yields. By May 30 - the day before the Morgan and Deutsche Bank issue - yields on two-year Treasuries were 6.60%, the lowest they've been in years. Those yields had been at 6.84% on May 20.

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