Making Sense of the Corporate Bond Market in These Amazing Times

close-look-chart-ssUsually, when the supply of the asset hits record levels, one expects the price of that asset to fall.

Through Thursday morning, August 21 2014, Dealogic, a provider of financial data, reported that, worldwide, corporations had issued just under $1.0 trillion in corporate bond issues.  The 2014 total is more than 4.0 percent above the figure reached one year ago.

This is the third year in a row that corporate bond sales have risen to new record highs through this time of the year.

So the supply of corporate bonds is up…and up strongly.

What has happened to corporate bond prices?

Since the end of 2013, corporate bond prices have risen!

Let’s look at this in terms of interest rate yields, which move in an opposite direction to bond prices.

At the end of 2013, corporate Aaa bonds, as reported by the Federal Reserve System, yielded 4.57 percent.  On August 22, 2014, Aaa-rated bonds yielded 4.03 percent, a decline of 54 basis points over the year-end number.

And, this is the face of a record supply of corporate bonds.

At the same time, corporate Baa-rated bonds fell from a yield of 5.37 percent at the end of 2013 to yield 4.66 percent on August 22, a decline of 71 basis points.

Not only did yields fall…and prices rise…but the corporate bonds that were assessed to be riskier fell by more than their less risky companions.

This just represents the drive for yield among investors in bonds, but it also gives one an idea about the supply of funds available to invest in bonds.

That is, the drive for yield among investors along with the amount of funds available to these investors to invest in bonds drove the demand for bonds to exceed the supply of corporate bond issues coming to market.

Hence, the demand for bonds exceeded the supply of bonds at the year-end level of bond prices, so the bond prices rose…and the yields on the bonds fell.

For the record, the yield on US Treasury securities also fell during this time period.  The 10-year Treasury note fell from 3.04 percent to 2.40 percent, a decline of 62 basis points.  Thus the spread between the Treasury issues and the Aaa corporate bond rose by 17 basis points suggesting that, in a marginal sense, more funds flowed into the Treasury market than into the corporate market…but the difference is really quite minor.

The corporations just cannot stay away from a market demand like this.  Executives saw corporate Aaa rates around 3.50 percent in the middle of 2012 but only for a short time.  Other than that, they have not seen such low rates in their professional careers.

Through the current economic recovery, which began in July 2009, corporations had not raised funds for expenditures on capital goods.  The economy had just not been strong enough and there was a substantial amount of uncertainty around about government policies that executives just did not want to commit to building up plant and equipment.

Expenditures for capital goods still remain weak historically, but raising funds in the bond market for this use “have risen by 90 percent from a year earlier to $40.0 billion,” according to Wall Street Journal reporter Mike Cherney.

I know…$40.0 is a pretty small chunk of $1.0 trillion…but, at least, it is moving up aggressively.

The major uses of funds gained by issuing corporate bonds not changed much over the past five years.  Let me just list them now for further discussion below.  The uses are to refinance existing debt that carried higher interest rates; to return money to shareholders in the form of higher dividends or buying back corporate shares…or both; to build up cash assets; and to use to acquire other firms.

The very, very low interest rates are certainly a reason to refinance existing issues that bear higher interest costs.  Issuing long-term debt with low interest can lower the cost of capital to these organizations for a long, long period of time.  Not a bad use at all.

Corporations that were relatively healthy came into the period of economic recovery with fairly sizeable amounts of cash assets on their balance sheets.  It was expected that a large amount of these cash assets would be used to acquire other less healthy companies and relatively low valuations.

With interest rates so low, more and more corporations issued debt to build up their cash positions, in many cases, to prepare themselves for an acquisition boom.

Although the boom has never really materialized as expected, M&A activity has picked up over the past eight months or so.  So, some of the reasons given for currently raising debt are to use the debt for acquisitions…but this is still a relatively small amount of the $1.0 trillion issued.

Two years ago or so, corporations realized that they could not just sit on their cash assets…shareholders demanded that they do something with the funds.  Corporate executives realized that the funds could be used to make shareholders happier by either providing the shareholders with more dividends or by buying back some of the shares of stock outstanding.

And, as the interest rates on bonds remained so low, corporations issued even more debt to pay higher dividends or to buy back more stock.  The opportunity cost of the borrowing was too low to resist.

We are really observing the bond markets in some amazing times.  To have imagined such circumstances a year ago would have been nearly impossible.  To have put out such a forecast would have been met with derision.  But, these market conditions have come about.  Now, it is important to learn from these times even though the probability of returning to such a condition in the future is extremely low.

About John Mason
 John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.


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