Institutional investors are taking a cue from individual investors: They're clipping coupons.
A month ago, the yield on the most-active two-year Treasury note swelled to 1.98 percentage points over the federal funds target, the widest level since 1995. That's allowing investors to pocket the difference between the rate at which they borrow to pay for the securities and the fixed payment they receive from them.
The current gap, at 1.50 percentage points, still means almost US$4,200 can be made in a day in interest on a US$100 million investment.
"This could end up being a very profitable option this year," said William Kirby, co-head of government bond trading at Prudential Securities Inc.
Two-year yields at 3.2 percent and higher are "cheap with [the Fed target] at 1.75 percent.
With price appreciation in Treasuries doubtful in coming months, investors and traders are using the interest-rate cushion to boost their profit.
"Hedge fund managers and others are putting this into the equation when buying two-year notes," said John Spinello, a bond strategist at Merrill Lynch & Co. "Financing is part of it. As long as [Fed] rates don't skyrocket, you can generate a lot of income."
Merrill has been buying and holding two-year debt, he said.
The risk to holders of two-year notes is that Fed rate increases will likely depress the price of the security as well as raise the cost of financing. Some investors say the trade makes sense only if you think the Fed won't raise rates for the rest of this year.
"You can make money, but it's about 50-50 odds and with those odds, I don't play," said Michael Cheah, who manages US$1.5 billion in government securities for SunAmerica Asset Management.
"Who knows what the Fed will do? It's a crapshoot."
The yield on the August federal funds futures contract, a gauge of expectations for the target's average that month, fell 1 basis point today to 1.85 percent. That indicates traders see about a 66 percent chance for a quarter-point rate rise at the Aug. 13 Fed meeting, down from a 100 percent probability a little over a week ago.
"The Fed may wait until September" to raise rates and might increase the target by a half-point, said John Nyhoff, chief economist at Tokyo-Mitsubishi Futures, Inc. in Chicago.
The Fed cut the target 11 times last year by 4.75 percentage points to a 40-year low to help the economy climb out of recession. It hasn't boosted rates since May 2000.
Two-year yields have fallen more than 35 basis points in the past month as a rise in the unemployment rate, a drop in consumer confidence and weak stocks added to evidence an economic recovery remains fragile.
The benchmark Standard & Poor's 500 Index has lost 7.2 percent this year.
"Anyone who did the [two-year note-fed funds] trade a month ago would have done well.
There's less of a cushion now," said SunAmerica's Cheah.
Prudential's Kirby, who said the 5.8 percent annual pace of growth in the first quarter showed signs of strength that will be hard to sustain, giving Fed Chairman Alan Greenspan more time before raising rates.
Analysts in this month's Blue Chip Economic Indicators survey lowered forecasts for US growth, saying the economy's expansion will slow to an annual 3.1 percent rate in the second quarter.
"I've been buying twos of late, and more people have been moving in that direction on expectations the Fed will wait longer," Kirby said.
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