The 10-year hits 5.1%, its highest since 2007

The benchmark 10-year US Treasury yield rose to 5.104 per cent on 25 September, its highest since the summer of 2007, just before the global financial crisis. The trigger was a very poor $70 billion auction of five-year notes that tailed heavily, a sign that primary dealers have run out of room on their balance sheets.

Dealers left holding the notes

The Treasury put $70 billion of five-year notes up for sale. Bids from end investors dried up, and primary dealers had to take an uncomfortably large share of the issue themselves. When that happens the message from the market is hard to miss, and it is that there is more US federal debt on offer than buyers want. At a benchmark yield of 5.10 per cent, investors at home and abroad are demanding ever higher returns to fund trillion-dollar deficits in peacetime.

Reading an auction

An auction tails when the yield at which it clears is higher than the rate traders were quoting in the minutes before bidding closed, which means the Treasury had to pay more than the market expected to sell the full amount. Bids come from three groups: indirect bidders, a category that includes foreign central banks and many fund managers; direct bidders, who bid for their own accounts; and the primary dealers, who are obliged to bid and absorb whatever others do not take. A large tail combined with a heavy dealer allocation is the clearest sign of weak end demand.

Dealers must then finance that inventory, usually in the repo market, and sell it on at a loss if prices keep falling. That makes them warier at the next auction, so weak demand at one sale can feed weakness at the next. The comparison with 2007 is uncomfortable for a different reason: the ten-year yield was last this high in the months before the credit crisis broke that August, when a rising cost of money exposed borrowers who had assumed it would stay cheap.

The five-year maturity matters to companies in particular. Much investment-grade corporate debt is issued in the five- to ten-year range, and bank loans and private credit are often priced over similar horizons, so a failed five-year auction raises the benchmark for the debt corporate treasurers are about to roll over. Foreign demand is the swing factor: official holders have grown more wary of adding to dollar reserves since Russia's were frozen in 2022, and private foreign buyers weigh the yield against the cost of hedging their currency exposure, which rises with American short-term rates.

Refinancing gets expensive

For corporate America, a risk-free rate of 5.1 per cent turns the coming wall of corporate debt maturities, worth several trillion dollars, into a real balance-sheet problem. Thousands of companies that borrowed at two and three per cent during the pandemic now have to refinance at benchmark rates above five per cent, before adding their own credit spreads.

The mechanics are unforgiving. When the Fed cut rates to near zero in March 2020, companies rushed to issue long-term bonds at the lowest coupons on record, and many pushed their maturities out several years. Those bonds are now coming due. A company replacing a bond with a three per cent coupon at a total cost of six or seven per cent doubles its interest bill on that debt, which lowers its interest coverage and can push a rating down a notch, raising the cost again at the next refinancing.

Who can wait it out

The squeeze is uneven. Large companies holding more cash than debt now earn more on their deposits than they pay on bonds issued years ago, and they can let debt mature without replacing it. Firms rated just above junk face the risk that a downgrade pushes them into a market where many investors are not allowed to follow. Leveraged borrowers with floating-rate loans have felt higher rates since the Fed began tightening, and a higher long-term rate removes their hope of refinancing into cheaper fixed-rate debt. Private credit funds, which have lent heavily to such firms, are likely to find out how well their loans hold up.

Commercial property owners face the harshest version of the arithmetic. Their loans typically run for five to ten years and end with a large repayment, and many buildings, especially offices, are worth less than when the loans were made. A higher benchmark raises the refinancing rate at the same moment as it lowers the building's value, leaving owners to inject equity, sell or hand the keys to the lender.

Room for relief

The case against a wave of defaults is that companies have had years to prepare. Many investment-grade issuers have already refinanced, credit spreads have been narrow, and companies can cut buybacks, sell assets or draw on cash before they miss a payment. A yield of this level may also prove temporary if the economy slows and investors return to Treasuries. The weakest borrowers, however, cannot wait for relief that may take a year or more to arrive.

The signs to watch are the results of the next two-year, five-year and seven-year auctions, credit spreads on bonds rated just above and below investment grade, and default rates reported by the rating agencies. At 5.1 per cent, the 10-year yield is at its highest since 2007, and four years of rising rates have now reached the corporate balance sheet. Over the next couple of years, cash-rich companies should be able to roll over their debt, while heavily leveraged ones are likely to struggle and some will probably default.