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Tuesday, December 9, 2008

The Bond Market's Irrationality Causes More Problems for Harvard

I wrote on December 3 that Harvard University's planned to issue long term bonds to fund current expenses as a consequence of the investment losses by its endowment. I wrote that by trading on its AAA credit rating and the historic low levels of long term treasury interest rates the decision would like turn out to be quite a good bond "trade" as the university would lock in very low borrowing rates. I expected their AAA credit rating (there are only a handful of US corporations with a credit rating of AAA) and the unlikely scenario that Harvard would default on its bonds would let them borrow at a small spread over treasuries......

Well I was wrong, big time. Bond market investors demanded a massive spread over treasuries on the Harvard bonds. The WSJ reports

Harvard Sells $1.5 Billion in Bonds


Harvard University raised $1.5 billion Friday in taxable bonds, with proceeds earmarked to repay short-term debt and to terminate certain interest-rate swap agreements, among other purposes.

The sale comes as the Ivy League university prepares to sell $600 million of tax-exempt bonds in the coming week to redeem debt such as short-term variable-demand obligations as well as to close out interest-rate swap contracts. Both the taxable and tax-free bonds received triple-A ratings from Standard & Poor's.

The fund raising comes days after Harvard reported that its endowment fund had investment loses of at least 22% in the first four months of the school's fiscal year.

The university raised $500 million each in five-year, 10-year and 30-year maturities. The five-year portion was priced to yield 3.35 percentage points above Treasurys, while the other maturities yielded 3.375 percentage points more than Treasurys . Based on recent prices, the 30-year bond would yield around 6.41%.

(To put the above number in perspective: as recently as last June below investment grade (junk) bonds carried a yield 2.5% above treasuries).

the article continues:

"It's a good pricing, coming right on top of single-A corporates like IBM," said Gary Pollack, head of fixed-income trade and research at Deutsche Bank Private Wealth Management. IBM five-year notes trade about three full percentage points over comparable Treasurys, "so you're getting a triple-A bond for the same level."

I assume he meant good pricing for the investory which it is. Talk about irrationality a buyer of these bonds can upgrade from a single A credit to AAA Harvard and increase his yield by .35% If and IBM bond default is unlikely, how unlikely is a default by Harvard University ?

Harvard spokesman John Longbrake declined to comment on the bond sale.

The university's financial report on its fiscal year ended in June, attached to the bond prospectus, noted that it lost $15.6 million in that year on interest-rate swap contracts, up from a loss of $7.9 million in the previous year. It entered into these agreements to manage interest-rate risk when converting variable-rate borrowings into fixed-rate debt, not for trading or speculative purposes, the prospectus said.

(translation of the above: Harvard locked in fixed rate borrowings based on rates for treasury bonds last year that were far higher than current rates. Now it will be hit with a double whammy effectively realizing the loss on its bet on the direction of treasury rates but also paying an interest rate premium over treasuries on its bond issuance which is in the range of 2.75% higher than it would have been a year ago.)

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