Beware of the Bond Bandwagon
Recent data shows that investors are flocking to bonds and bond mutual funds in overwhelming numbers. The image of the thundering herd comes to mind as economic fears and stock market volatility has instilled fear amongst investors. Recent comments from PIMCO, which runs the world’s largest bond mutual fund, indicate that they are taking in over a billion dollars of capital from investors looking to invest in bonds.
The rout in interest rates has allowed corporations to borrow money from the bond market at some of the lowest interest rates on record. Recently, IBM was able to sell 3 year bonds paying only 1% in interest and Johnson and Johnson was able to issue ten year bonds that only cost the company 3.1% in interest annually.
For corporate America, things have seldom been better. It is estimated that US businesses have nearly $1.5 trillion in cash on their balance sheets and are able to borrow at the most attractive interest rates in decades.
The chart above compares the current dividend yield being earned by shareholders of IBM, McDonald’s and Johnson and Johnson. By looking at the comparison, we can see that the shareholders (owners) are getting paid almost as much or more as the lenders (bond owners). It should be kept in mind that these companies have annual dividend growth rates that that are 16.80%, 28%, and 14% respectively.
If these companies were to continue to grow their respective dividends over the next ten years at the same rate as the last ten years, then the income earned by shareholders would far exceed the income received by the bond holders of these companies. For example, in the case of Johnson and Johnson, if the company could continue to increase its dividend for the next ten years as it did for the last 10 years, its current dividend yield would rise to almost 14% while the bond holders who just purchased the recent bond issue highlighted below would continue to receive a fixed 3.10% interest rate for 10 years.
IBM raised $1.5 billion at the lowest interest rate on record as the credit rally that began in June extended into August on investor confidence the economy won’t slip back into recession.
The 1 percent, 3-year notes from IBM, the world’s biggest computer-services company, have the lowest coupon of the more than 3,400 securities in the Barclays Capital U.S. Corporate Index of investment-grade company debt. Dearborn, Michigan-based Ford Motor Co.’s credit rating was lifted two steps by Standard & Poor’s.
Investors are wagering on corporate America’s debt with 75 percent of S&P 500 index companies reporting profits that exceeded analyst estimates. U.S. manufacturing growth slowed less than economists estimated and Federal Reserve Chairman Ben S. Bernanke said the central bank is “maintaining strong monetary policy support” for the economy.
“Even though the economy isn’t working to its fullest capacity, a lot of investors are feeling that if companies are capable of turning in decent earnings, then they’re able to manage themselves to this low-growth environment,” said Arthur Tetyevsky, chief U.S. credit strategist at Gleacher & Co. in New York.
Borrowers sold $12.9 billion of U.S. corporate bonds yesterday, according to data compiled by Bloomberg. Citigroup Inc. issued $3 billion of notes, following July sales by Goldman Sachs Group Inc. and JPMorgan Chase & Co.
Credit-Default Swaps
The extra yield investors demand to own company debt instead of government bonds fell 1 basis point to 176 basis points, or 1.76 percentage point, the Bank of America Merrill Lynch Global Broad Market Corporate index shows. Average yields rose 1.6 basis points to 3.767 percent.
Credit markets rallied as the gap narrowed from 201 basis points on June 11 amid growing confidence Europe’s sovereign- debt crisis was under control.
Elsewhere in credit markets, the cost of protecting corporate debt in the U.S. rose, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on company debt or speculate on creditworthiness, climbing 0.48 basis point to a mid-price of 99.62 basis points as of 11:44 a.m. in New York, according to Markit Group Ltd. In London, the Markit iTraxx Europe Index of swaps on 125 companies with investment-grade ratings dropped 3.3 to 96.59.
Both indexes, which are at the lowest since May 13, typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of bonds and loans.
Household Spending
Rising wages will probably spur household spending in the next few quarters, even as weak job gains drag down consumer confidence, Bernanke said yesterday in a speech in Charleston, South Carolina.
“We are maintaining strong monetary policy support for the recovery,” Bernanke said in response to an audience question, without discussing further action the Fed could take to aid growth.
U.S. employers cut 60,000 jobs in July, the second straight drop in non-farm payrolls this year, according to the median estimate of 77 economists in a Bloomberg survey before the Labor Department reports the data Aug. 6.
The Institute for Supply Management’s manufacturing gauge dropped to 55.5 last month, exceeding the median forecast of economists surveyed by Bloomberg News, from 56.2 in June. Readings greater than 50 indicate growth. The group’s bookings gauge, considered a leading indicator, fell to a one-year low.
Bond Issuance
Companies sold $90.1 billion of U.S. corporate bonds last month, the most for July since at least 1999. Average yields on the securities fell to 5.01 percent on July 31, the lowest since April 2004, according to Bank of America Merrill Lynch index data.
Sales yesterday were the busiest since July 21, when the total reached $12.9 billion, Bloomberg data show.
“It’s a very good time for companies to be issuing debt and they have excellent balance sheets that they’re leveraging as well,” John Herrmann, a senior fixed-income strategist at Boston-based State Street Global Markets LLC, said yesterday in a Bloomberg Television interview. “We have extremely low rates and yet at the same time investors are searching for yield over Treasuries.”
IBM’s bonds were priced to yield 30 basis points more than similar-maturity Treasuries, data compiled by Bloomberg show. The company, based in Armonk, New York, last sold debt in November, issuing $750 million of two-year floating-rate notes and $1.25 billion of 3.5-year fixed-rate securities.
Citigroup Bonds
Citigroup’s bonds were sold in a two-part offering, according to data compiled by Bloomberg. The $2.25 billion of 10-year notes pay 255 basis points more than similar-maturity Treasuries, and the $750 million of debt sold through a reopening of its notes due in 2015 yield 4.182 percent, the data show.
The sale was Citigroup’s biggest since September when the bank sold $5 billion of notes guaranteed by the Federal Deposit Insurance Corp. in a four-part offering, Bloomberg data show.
Citigroup may sell as much as $21 billion of debt this year, up from an earlier target of $15 billion, Treasurer Eric Aboaf said in a July 22 interview with Bloomberg News. Goldman Sachs, JPMorgan and Morgan Stanley issued a combined $8.9 billion of bonds last month.
Ford’s credit ranking was raised by S&P to B+, four steps below investment grade, from B- on expectations the company will remain profitable and amid signs that customers have a better impression of the automaker’s vehicles, the ratings company said yesterday in a statement. The outlook is positive.
Ford has “substantial” cash balances and likely will continue to generate free operating cash flow, the ratings company said. Consumers have an “improved perception” of Ford’s vehicles and its efforts to introduce more fuel-efficient models in the next few years, S&P said.
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