Recently I came across a news item that caught my fancy:
“Corporate bond sales hit record. Corporate bond sales surged to a record annual high of $1.171T YTD – more than the $1.167T sold in all of 2007 – as companies take advantage of low interest rates to rebuild their balance sheets. Companies that could not sell debt during the financial crisis are borrowing more aggressively, and being careful to sell debt with longer maturities to avoid being trapped by refinancing risk as they were in 2008, analysts said. The bond sale surge was also supported by the FDIC’s debt-guarantee program – companies issued $200B of debt guaranteed by the FDIC this year before the program ended on Oct. 31.”
The rationale for companies issuing a record amount of bonds this year makes total sense to me – take advantage of the current low interest rates. But if interest rates are going to rise in the future (it must be true – “everyone” says it going to happen…), why would investors want to buy this record level of bonds at these unusually low rates? Is a puzzlement…
I’ll be the first to admit that I am not an expert on bonds. Most of my career has focused on the equity market. To me, the formula for bond investing always seemed a bit simplistic – interest rates up, prices down, and visa versa. Clearly this view grossly understates the complexity of the marketplace, but it is where I begin with bonds. Fortunately, I know a lot of very smart people who are very good at bonds.
So, I turned to some of my smart friends to answer the puzzling question above. Through these discussions I learned a number of important things about the world in general and the bond market in specific.
- The World is a Safer Place Now. With both the credit crisis and recession fading into the past, investors are once again comfortable with owning assets other than cash. Stocks still may be viewed with some skepticism, but bonds yielding 2-4% are much more attractive than cash yields near zero. So part of the enthusiasm for bonds is an asset allocation shift from cash to bonds.
- Stimulus Money Needs a Home. The $3-4 trillion (more or less) in government stimulus money already spent needs to go somewhere. We have seen the impact of all this liquidity in lots of places – commodities, oil, gold, stocks and bonds. Given the huge size of the bond market, it would not be surprising that it received a majority of this cash injection. Oh, and the bulk of the approved stimulus spending is yet to come.
- Inflation vs. Deflation Debate Good for Bonds. Although many expect inflation to eventually pick up sometime in the future, some of the credible bond market commentators are still warning about the threat of deflation. Deflation is especially pernicious because it’s so hard to fix (consider Japan’s 20-year fight with it) once it takes hold. Whether or not deflation becomes a problem, the fact that it’s still being mentioned as a threat gives many bondholders comfort that inflation will not be a problem in the near to medium term and that interest rates may remain stable for longer than most expect.
- Low Interest Rates Benefit Many “Important” Groups. The aggressive monetary easing we are currently experiencing benefits a large portion of the economy, but especially the auto industry, the housing market, the banking industry (have you seen bank profits lately?), and other stressed groups. Thus, bankers, politicians, unions, and lots of other highly-visible groups really, really like the status quo. At some point, the Fed may see the need to raise rates, but we can image that Mr. Bernanke is being bombarded by many voices urging him to wait as long as he can. This delay would be good for bond investors as well as these other groups.
- The Futures Market is Calm. Although not an exact guide for what may happen in the future, the Fed Funds Futures market can give us a clue what investors are expecting from short-term rates down the road. Right now this market is looking at a 1.35% Fed Funds rate by the middle of 2011. This too argues that few expect any kind of aggressive tightening of monetary policy within the next 18 months.
So, what’s not to like about bonds? Well, low yield for one. Is the 10-year US Treasury bond a steal at 3.4%? We are still seeing some deals in the corporate arena, but for the most part bonds look like “everyone” already loves them. Does this make me bearish on bonds? Not really. I can also see the logic of owning them versus cash.
I guess my view on bonds is mixed, but the current enthusiasm for bonds does, at the margin, make me a little more bullish on stocks. Why so? The investors who were able to leave the perceived safety of cash for a little more yield in bonds will eventually find bond returns unacceptably low and turn to stocks. The fact that this hasn’t happened yet gives me comfort that the new bull market has room yet to run.