A Cinderella effect is currently underway in the bond market, as treasury bills — once considered the dull sister of much riskier long-term bonds — are now being seen as downright glamorous. Risk is out; safety is in — and nothing is safer than those short-term government bonds.

In the wake of the August stock-market tailspin and the torment that has rocked U.S. and Canadian debt markets, several U.S. hedge funds loaded with subprime mortgages have become insolvent, unable to meet cash calls from unitholders.

In Canada, much asset-backed commercial paper has become illiquid as investors run for cover. Banks that were thought ready to provide liquidity — that is, bids — to the pipes of the ABCP system in the event that market seized up have said they won’t buy orphaned paper. At least, not in every case, say the banks, which are referred to as “conduits” in the ABCP markets.

In the last week of August, Bloomberg LP reported two dozen Canadian companies that had used ABCP failed to get redemptions on time. As Harry Koza, senior analyst for Canadian credit markets with Thomson Financial Corp. in Toronto, says: “Every day, another hedge fund, collateralized debt obligation or ABCP conduit is carried off the field on a stretcher.”

Bond-rating agencies are blaming the banks for not keeping their promises to provide emergency liquidity. In turn, the banks are blaming ABCP buyers and the credit-rating agencies for not reading the covenants more closely. The concept was that the banks would buy orphaned commercial paper in the event of a general ABCP breakdown. “If this is not a general breakdown, what is?” asks a Bay Street player.

T-bills are now being purchased by investors willing to pay any price for safety. As a result, T-bill yields tumbled as low as 1.8% during the mid-August U.S. T-bill-buying panic, down from an early August level of 4.6%; yields recovered to 4% in early September

Bankers’ acceptances — the IOUs of the chartered banks — have recently sold off so much that their yield has jumped as high as 4.7%, which is as much as 120 basis points more than T-bills of the same term. In contrast, BAs yielded just 10 bps over T-bills of similar terms as recently as June.

But that was summer and this is fall. Although the markets are recovering, risk aversion is still the order of the day. An economic slowdown caused by tight credit markets would ordinarily cut bond yields; but in a market terrified by credit-quality issues, yields could rise to reflect higher risks.

To be sure, there is reason for apprehension. In Nevada, one in 67 homes is in foreclosure — the worst rate of mortgage insolvency in the U.S., the CNBC television network reported in August.

It is no wonder U.S. housing prices are plummeting as lenders try to clear their inventory of what has been reported as more than one million houses for which there are no bids. Canada does not have an oversold housing market comparable with U.S., but the fear that chartered banks have feasted on high returns from U.S. mortgages that have now defaulted helped clobber market value in August.

U.S. mortgage problems have come home to roost in Canada. The threat that the Bank of Canada might raise rates later this year is not having a strong effect on investment-grade bonds. The market is leaning toward a cut in rates, but the Bank of Canada has made no commitment either way, allowing for a rate increase later this year, says Robert Marcus, chief investment officer for specialist bond investment firm Majorica Asset Management Corp. in Toronto. Ordinarily, a rate hike would depress existing bonds with relatively low coupons. This time, money coming out of stocks has been heading to the safe haven of bonds — regardless of yields.

But while government-bond prices have risen, some investment-grade corporate bond prices have fallen, notes Peter Kotsopoulos, executive vice president of fixed-income at Toronto-based money manager McLean Budden Ltd. Bank bonds, in particular, have been under pressure.

In early September, a Bank of Montreal bond with a 5.10% coupon due April 21, 2016, was priced to yield 5.38%, compared with a Canada bond of similar term that was priced to yield 4.40%. “We are close to the levels of the last credit crunch in 1998, but this one is potentially more severe,” says Brad Bondy, vice president of fixed-income at Genus Capital Management Inc. in Vancouver.

@page_break@“The wide spreads on bank bonds reflect global credit market concerns,” Kotsopoulos says. “Foreign bond spreads are also affected. The fear is liquidity will dry up and credit spreads will widen further.”

This is a Darwinian process: liquidity is being squeezed out of the riskier end of global markets; money is going to only the best credits.

The most dramatic indicator of credit conditions is the price of high-yield debt. These prices, which move opposite to interest rates, have collapsed. In August, the most prominent indicator of the high-yield market, the Merrill Lynch Master II index, showed a spread of 420 bps over U.S. treasuries, up from a spread of 235 bps in June. Still, that spread is far less than the spread of 1,100 bps seen at the bottom of the dot-com meltdown in 2002.

How long this credit crunch will continue is an open question. What happens in retail residential lending will have a huge effect on both bond and stock markets.

“It may take years for the mortgage problem to be worked out,” Kotsopoulos notes. A third of the Lehman Brothers U.S. aggregate bond market index is now made up of mortgages, he adds.

So, when will the subprime turmoil end? Says Bondy: “We’ve seen a deepening of concerns by inves-tors. The lack of liquidity causes credit concerns to be magnified. If there is a lot of liquidity, credit concerns tend not to surface.”

If U.S. consumers, affected by the housing crisis, restrain their spending, it could lead to an economic slowdown. Indeed, there are signs a slowdown is underway. In early September, Ford Motor Co. announced a 14% decline in August sales as consumers shied away from taking on more debt.

T-bills are looking better with every passing day. IE