Be careful what you wish for. That’s how to best describe the latest Public-Private Investment Plan (PPIP) announced by the Treasury last month and its unintended consequences on debt financing

Through their combined and unprecedented resolve to spur liquidity back into fractured credit markets over the past 18 months, the Federal Reserve and Treasury have inadvertently created a two-tier market for bond financing. That’s because several major credit initiatives are supported by aggressive Fed and Treasury funding into the most distressed or important markets while leaving others without government funding; this has created opportunities to arbitrage the markets where the government is active or attempting to reduce interest rates.



For example, over the last five months the Fed has purchased more than $300 billion dollars’ worth of mortgage agency debt in order to pressure consumer lending rates lower and spur lending. That move, announced earlier in November, has triggered an arbitrage trade for big bond investors and hedge funds running to buy mortgage agency debt as they ride the Fed’s coattails. That strategy has worked profitably as mortgage agency yields have plummeted since last fall.

The same is true for municipal bond debt whereby many states are effectively broke. Yet again, it’s the Feds to the rescue. The government has already passed legislation to distribute federal aid to states in order to help them narrow their bulging budget deficits. Several states, including California, are bust. Municipal bond prices have rallied sharply since January; without the government’s assistance, muni bonds would have probably crashed.

Now we’ve got Tim Geithner’s PPIP on deck.

The Treasury Secretary plans to finally segregate toxic assets away from bank balance sheets and into a public-private pool of investors to isolate a long-term pricing mechanism. This idea, though bold, will probably siphon-off some risk capital away from junk bond markets. With the prospect of generating big double-digit yields and capital gains from FDIC-assisted leveraged financing through the PPIP, hedge funds and other investors won’t lunge after high-yield bonds where the government is not bridging loans or created an alternative capital funding platform. Many distressed companies that are below investment grade are struggling to raise funds.

The problem with all these bailouts and capital assistance programs is that they’re already creating a two-tier market; some markets, like mortgage agency debt, municipal bonds and highly toxic distressed mortgage-backed securities come attached with effective federal subsidies as the government actively purchases these securities. But, at the same time, other segments of credit like junk bonds, investment grade debt, leveraged loans and emerging market debt are not receiving government assistance and thereby isolating important parts of the credit system.

Over the long-term, massive federal assistance creates an environment of dependency as markets become accustomed to government liquidity.

Just how the government plans to exit these operations without creating a serious back-up in rates in the process will be a difficult task once the credit system finally stabilizes.

The next target for the Fed and Treasury might be investment grade debt markets but only once all the uncertainty lingering over the bank sector is resolved.

Despite the big rally in stocks since March, credit spreads for the safest segments of fixed-income has surged. Over the last week alone credit spreads rose from 7.04% to 7.11% based on the Dow Jones Corporate Bond Index while the S&P 500 Index gained another 3.3%.

The federal government is unlikely to intervene in investment grade credit markets until more clarity unfolds surrounding the faith of senior bank debt. If partial or full bank nationalization is inevitable, and I believe it is, then investors will remain reluctant to own senior bank debt and subordinated debt until this uncertainty is resolved. And for investment grade indices – holding more than 40% in financial sector bonds – that means more volatility lies ahead.