Pensions Fueling Corporate Bond Bubble?
Sales of long-term US corporate debt this week surpassed the entire amount sold in 2011 in what is shaping up as a banner year for long-term funding.
The combination of rock-bottom borrowing costs and hunger for alternatives to low-yielding Treasury debt from institutional investors, who tend to favour longer debt maturities, is encouraging global companies to come to the US capital markets and offer benchmark 30-year bonds.This week, Philip Morris International, Walt Disney and Shell International Finance joined other companies to sell more than $3bn combined in long-term debt.
This comes as companies including United Technologies, SABMiller, Monsanto and even banks, such as Morgan Stanley, sold a total of $86.3bn in 30-year bonds in the year to date.
This compares with overall sales of $84.7bn for 2011, according to Dealogic. Further, the total amount sold so far this year is nearly double the volume sold over the same period last year.
“When you can price debt that cheaply for 30 years, it behoves companies to consider doing it,” said Adrian Miller, a director for global market strategy at GMP Securities.
“It makes total sense for some [companies] to take advantage of that opportunity, even if they are not particularly pressed to raise new funding,” Mr Miller said.
Long-term debt is particularly attractive to pension and retirement funds as well as insurance companies. That group of investors tends to favour 30-year bonds as such debt duration matches the long-term nature of their obligations to retirees.
Indeed, US pension funds have been negligible buyers of US Treasury debt this year, according to Federal Reserve data. Instead, they have increased their corporate credit exposure and cut exposure to equities.
“This is a risk management exercise by pension plans to immunise their liabilities and not try and seek outperformance,” said Ashish Shah, head of credit at AllianceBernstein.
Debt sales have accelerated in the past month and accounted for roughly a quarter of total corporate issuance in a busy August, as companies sought to place long-term debt ahead of a slowdown in activity towards the end of the US summer holidays.
The sweet spot for long-term borrowers came as the Fed pledged in January to keep rates low at least until 2014, and the yield on the US Treasury long-bond touched a record low of 2.44 per cent in July.
The performance of long-term corporate bonds has also been strong. At 9.9 per cent, the year-to-date return on long-term investment grade debt exceeds that of intermediate duration bonds by more than 3 percentage points. Long-term corporate bonds have also achieved returns 5 percentage points higher than the return of US Treasuries maturing in 20 years or more, according to Barclays indices.
There is no doubt about it, investors are piling into corporate debt, prompting fears of another bond bubble.
Peter Latman of the NYT reports, Risk Builds as Junk Bonds Boom:
Money market funds pay next to nothing. Interest rates on United States Treasuries are dismal. The volatile stock market has been dead money for more than a decade.
But on Wall Street — as the old saying goes — somewhere, someone is making money. And these days, that somewhere is junk bonds.
The market for junk bonds, risky corporate debt that pays high interest rates, is red hot. Such debt, also known as high-yield bonds, has returned 10.2 percent year-to-date, according to a JPMorgan high-yield index. Junk bond funds are on a pace to take in a record amount of money this year. Companies with less than stellar credit are issuing hundreds of billions of dollars of bonds.
Fueling this frenzy are investors of all stripes — including individuals, mutual funds and state pensions — who are desperate for returns in their bond portfolios and willing to take more risk to get them. Demand is insatiable, even as analysts warn that the market has become overheated and is ripe for a fall.
“In a yield-starved world, high-yield bonds are right now the only game in town,” said Les Levi, a managing director at the investment bank North Sea Partners. “The market is giddy.”
But a funny thing has happened as everyone has piled into this bond market: high-yield bonds have become something of a misnomer.
The average yields on these bonds have dropped to 6.6 percent, hovering near a record low, according to the Barclays high-yield index. Historically, the interest rate paid on high-yield bonds has been 10 percent or higher. And over the last weeks, several companies have issued speculative-grade debt at yields hardly ever seen in the junk bond market.
“It’s amazing: You’re now seeing 4 to 5 percent yields for weaker companies,” said Adam B. Cohen, founder of Covenant Review, a credit research firm. “These are the type of yields that you used to see for blue chips like Exxon and Pepsi.”
Consider the CIT Group, the small-business lender, which three years ago was on the brink of collapse. The company eventually emerged from bankruptcy, hobbled from the wounds it suffered in the financial crisis.
Late last month, investors snapped up $3 billion worth of bonds sold by CIT, which credit ratings agencies continue to view as a risky issuer. The company is paying an interest rate of 4.25 percent on one part of the bonds, and 5 percent on the other. CIT has raised almost $10 billion in junk debt in 2012, making it the year’s largest issuer of high-yield bonds.
The record-low yields in the junk bond market are a function of several factors.
First, they reflect the low-interest rate world that has persisted since the crisis. Treasuries are the benchmark for pricing high-yield bonds. Investors receive a higher interest rate for junk bonds, a so-called spread over Treasuries, because the risk of default is higher. And since interest rates on government bonds are so low — the 10-year Treasury is paying a paltry 1.8 percent — companies do not have to pay as much on their bonds.
Yields on junk bonds have also declined because the price of a bond moves inversely to its yield. So as junk bond prices have appreciated, yields have dropped. The return on a bond is made up of its interest rate and price appreciation.
Corporate borrowers look less risky, too. With the economy recovering, albeit unevenly, corporate default rates have fallen and are expected to stay low. The percentage of high-yield issuers that have defaulted on their debt in the last year stands at about 2.8 percent, according to Standard & Poor’s, well below the historical norm of 4.5 percent.
The modern junk bond market was built in the freewheeling debt binge of the 1980s. Michael R. Milken, a financier at the investment bank Drexel Burnham Lambert, initiated the issuance of high-risk, high-yield bonds to pay for hostile takeovers. The market collapsed in 1990 when Drexel declared bankruptcy and Mr. Milken pleaded guilty to securities fraud.
Today looks very different from the go-go 1980s. Companies issuing junk bonds are rarely using the proceeds to make big acquisitions or invest in new businesses. Instead, they are taking advantage of the record-low interest rates to refinance their balance sheets, replacing more expensive debt with cheaper money. By reducing borrowing costs — and in many cases pushing back loan maturities — these companies are reducing the risk that they will default.
“It is a very hospitable environment for issuers,” said Howard Marks, the chairman of Oaktree Capital Management. “If you want to fix a problem, you can fix a problem.”
Companies have issued record amounts of high-yield debt since the financial crisis. With $184 billion in new public issues sold this year, the market is on pace to approach 2010s record $264 billion in high-yield issuance, according to Thomson Reuters. This month, $25 billion worth of deals have occurred, the most for August.
Companies owned by private equity firms have benefited from the boom in junk bond issuance. Debt-heavy companies taken private in last decade’s buyout boom are strengthening their balance sheets by replacing more expensive debt with new high-yield bonds.
Even the most troubled businesses have been able to access the junk bond market. Energy Future Holdings, the Dallas-based utility acquired by the private equity firms Kohlberg Kravis Roberts & Company and TPG in 2007, has struggled amid low natural gas prices. Yet last week, the company raised $600 million in junk bonds, 20 percent more than it had planned to issue.
“It is fair to say that a very strong high-yield market is helping to keep Energy Future Holdings afloat for the time being,” said Peter J. Thornton, an analyst at the credit research firm KDP Investment Advisors.
Several Wall Street analysts said there had been very few periods when conditions had been so well suited to the high-yield bond market, both for the companies issuing the bonds and for the investors buying them. With the Federal Reserve saying that it intends to keep interest rates near zero through at least 2014, the demand for riskier, higher-yielding debt as an alternative to Treasuries is expected to continue.
While inflows into the stock market remain weak, investors are pouring money into junk-bond mutual funds and exchange-traded funds. This year, $20 billion has flowed into these funds, with $9 billion invested in the last nine weeks, Lipper said.
Still, a growing chorus of market players is starting to sound alarm bells. A recent report by Bank of America warned investors against diving headlong into junk bonds at these record-low yields. Not only is there little hope for additional price appreciation, but the companies issuing this debt are vulnerable to a cyclical swing in the economy and slowing business conditions.
“This is not a sustainable state of affairs,” wrote the Bank of America analysts Hans Mikkelsen and Oleg Melentyev in a recent report. “While the bid for high-quality yield is understandable in this environment, we question the extension of this reach into the economically and risk appetite-sensitive portions of the credit spectrum.”
Mr. Levi of North Sea Partners put it in plainer English, “This could pave the way for some heartbreak down the road.”
Are these fears justified? Last month, Jonathan Ratner of the National Post examined this issue asking, Is the corporate bond market in a bubble?:
With the yield for Moody’s BAA U.S. corporate bond indices hitting a low of 4.87% this week, it was just 9 basis points off the 4.78% level reached in March 1965. This has prompted concern that corporate bonds are following the same bubble trend as treasuries have.
“With Treasury bonds grossly overvalued, investors have moved up the risk ladder, which is exactly what we believe the Fed is trying to achieve,” said Martin Roberge, North American portfolio strategist and quantitative analyst at Canaccord Genuity.
His fair value estimate for U.S. BAA investment grade bonds is 6.4%, producing an overvaluation of 152 bps.
Mr. Roberge pointed out that this overvaluation rarely exceeds 100 bps and has never climbed above 200 bps in the past 50 years.
Will this time be different? The strategist expects it likely will be since corporate balance sheets are in far better shape than that of governments.
As a result, if investment grade bonds undershoot their fair value to the same extent that treasuries have (roughly 250 bps), Mr. Roberge sees yields potentially falling toward 4%. At that level, credit spreads to treasuries would be above the historical average of about 200 bps.
The strategist told clients that when a company like Enbridge Inc. is able to finance its pipeline expansion through a 100-year bond at only 185 bps above Canada’s (2041), “you know that the demand for corporate bonds is not likely saturated yet.”
My take is that there is a spectrum of the corporate bond universe that is pricing in ridiculously low risk, and thus vulnerable to an adverse event.
Having said this, corporate balance sheets are in excellent shape, especially if you compare them to government ones. As long as the Fed is committed to keeping rates low, investors will keep snapping up corporate debt, allowing companies to refinance their balance sheets, bolstering the economic recovery.
Below, Marc Faber, Gloom Boom & Doom Report, discusses his stance on politics, the U.S. economy, and the global markets. Faber thinks we put in the highs in stocks and is particularly worried about tech stocks. I disagree, risk assets will continue rallying. When companies like Cisco beat their forecast and raise the dividend, it's bullish for the tech sector.