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Look at the bond market these days and you might think we're heading into a recession. Trading volume is down, interest rates are rising, and credit quality among corporate issuers seems to be deteriorating. The result is increasingly illiquid fixed-income markets. "It has developed slowly, so we don't call it a crisis," says Marci Rossell, a vice-president and chief economist for Oppenheimer Funds. But bond market conditions now are what they typically would be if the economy were on the verge of stalling, not zooming along at 6% growth.
The bond market still tends to lead the economy's boom-and-bust cycles, so its current hangdog look may have less to do with imminent recession than it does with structural changes in how the bond market functions. Consider: The U.S. Treasury-bond market, once the largest in the world, is rapidly shrinking. The federal budget surplus means the government doesn't have to sell bonds to finance government spending. In fact, the government is using the surplus to buy back existing Treasuries and pay down the federal debt.
At the same time, the Federal Reserve Board is in a tightening mode even though inflation is comparatively low because it believes the economy's growth rate is too fast to sustain. Meanwhile, Old Economy companies have found it cheaper to issue debt than to sell stock, so they're piling debt on their balance sheets. Finally, technology is making trading more efficient, so many traditional market-makers are abandoning bonds as a money-losing business.
BIG HURT.
All these changes in the bond market are noteworthy in and of themselves. But even more startling is the potential impact they could have on corporate issuers. Companies are watching their credit ratings drop, and the interest they have to pay on their debt is rising. As long as economic prosperity continues, Corporate America should be O.K. But the Fed's much-sought-after economic slowdown is bound to affect earnings. That means early next year Old Economy companies could be hurting in a big way.
It's no secret that last year and through March of this year, these companies were buying back their stock cheap, financing the buybacks with debt. "So-called Old Economy stocks lagged the high-flying sectors by so much, it was almost incumbent upon them to initiate buyback programs," says Mark Ryan, senior fixed-income strategist at PaineWebber.
But the more these companies leveraged their balance sheets, the more they put their credit rating at risk. Credit-rating agencies are prone to downgrade a company's credit when its balance sheet becomes too debt-laden. In 1999, rating agency Standard & Poor's (owned by the McGraw Hill Companies, as is Business Week) downgraded 490 corporate credits, vs. 196 upgrades. So far in 2000, downgrades have totaled 254, vs. 74 upgrades. That's a big chunk of corporate issuers whose cost of debt went up at a time when their earnings reports have been good. But that cost could go up a lot further if earnings growth slows.
JUICY YIELDS.
You might think all these structural changes in the bond market would be slowing activity. To a great extent they are, but that wasn't the case the week of June 5-9. It was an extraordinary week, in terms of new bond-issue activity -- $16 billion worth of corporate bonds were issued, led by top-quality credits, such as Ford, Wells Fargo, and International paper. Compare that to the $6 billion monthly average for nongovernment debt issuance so far this year, and it's no wonder market watchers were tempted to call the week a watershed.
Appetite for top-quality debt may be strong, but those issuers are paying for it. On its $4.5 billion financing that week, Ford Motor Co. had to offer a yield of 7.9% on its $2.5 billion worth of 10-year bonds. That's 1.86 percentage points over the 10-year Treasury yield of 6.04%. "When you consider that the historical norm for equity returns is 7%, and investors could lock in an almost riskless 8%, it's no wonder the issue oversold," says Oppenheimer's Rossell.
A key reason why corporate borrowers are paying such high rates is the Treasury's debt buyback program. It has thrown pricing into confusion as buyers and sellers scramble to find a benchmark replacement for the 30-year Treasury bond, which threatens to disappear under the buyback. Corporate deals are being priced off the 10-year Treasury rather than the 30-year. And some analysts argue that the yield on 10-year Treasuries is artificially low because of the government debt buybacks. With so many buyers competing for the 10-year Treasury, the government doesn't have to offer a very high yield. That's why the yield curve that charts yields from the shortest to the longest maturity is inverted, i.e., you get a higher yield on a 5-year Treasury note than on a 10-year note.
PRICING INEFFICIENCY.
The unusually low Treasury yields have widened the spread between the rates that companies pay to borrow and the rates that the government has to pay. On average, a corporate issuer now pays about 1.2 percentage points above the 10-year Treasury rate, vs. an historical average spread of 0.85 percentage points, according to data from fixed-income portfolio manager Smith Affiliated Capital. Junk-bond issuers with high-risk credit ratings are paying around 6.4 percentage points over the 10-year Treasury rate.
And the idea of a truly "risk-free" bond is fast disappearing with each repurchased Treasury. Now, "when we do an equity deal, we don't price off a risk-free rate," observes Jack Malvey, a managing director and chief global bond strategist at Lehman Brothers. "We do a peer-group comparison. There is such a deep corporate bond market, we could do the same thing and price off a composite" bond rate. It's likely the bond market will be in a period of pricing inefficiency that will probably push corporate borrowing rates higher until a new risk-free benchmark is established.
The effects of the Treasury buyback could increase over the next few years. According to a study published by Goldman Sachs, if the buyback program continues at this pace, no publicly held government debt would be left by 2007 or 2008. Of course, these calculations don't take into account future income tax cuts, changes in government spending, or increases in inflation, bond analysts are quick to point out. "The budget surplus shocked the devil out of everybody, but that present can be taken back just as quickly as it was delivered," says Oppenheimer's Rossell.
DEARTH OF BUYERS.
Nonetheless, institutional investors, such as pension funds and large money managers, are making darn sure they've got plenty of Treasuries on hand as long as the supply lasts. Conventional wisdom among institutional bond managers is that about a third of their portfolio should be in Treasuries. But it's getting harder and harder to keep that percentage stable as the supply dwindles. Portfolio managers are paying higher prices for government bonds, which leaves them less money for investing in corporate bonds. "Institutional accounts have a tremendous anxiety about getting caught short in Treasuries. They are grudgingly investing in corporates only because the yields are compelling," says PaineWebber's Ryan.
With some exceptions (like the week of June 5-9), these factors have contributed to a dearth of buyers for corporate bonds. Bond mutual funds have seen tremendous outflows since the beginning of the year. The total net lending by mutual funds in the credit markets was a negative $70 billion in the first quarter of 2000, following a negative $11.7 billion and negative $18.8 billion in the preceding quarters, according to Federal Reserve data. That means a total of $130.5 billion of mutual-fund money was pulled out of the credit market in the past nine months.
At the same time that institutional investors are becoming tight-fisted, the traditional market-makers in the bond market are all but closing up shop. "Very few [Wall Street firms] are putting capital into a [bond] trading desk," says Robert Smith, president of Smith Affiliated Capital. "They're putting capital into developing online businesses. The ultimate extension of the new technology is that we're going to end up buying bonds and holding them to maturity because there will be nobody to make a market in them."
LIQUIDITY CRISIS.
Since 1998, Wall Street has been pulling back on bond trading as an unprofitable business. The amount of bonds held by bond dealers, the firms that are obligated to put in a bid when nobody else is buying, has probably dropped by as much as 40%, according to John Hague, a managing director and senior portfolio manager at California money manager PIMCO. In the second half of 1999, several top investment banks reassigned staff from fixed-income to other areas because of drooping profitability.
With pension funds running scared, mutual funds pulling out, and the bond market community dwindling, small wonder there is what, among themselves, bond mavens call a liquidity crisis. "The buyers just aren't there," says Oppenheimer's Rossell. For corporate issuers that means ever-increasing interest rates will be needed to entice buyers. The result: expensive borrowing for companies that already have a lot of debt on their balance sheets. And if the Fed raises interest rates again this year, the situation will be worse.
Even more troubling is that in an economic slowdown, the stock market is unlikely to be of much help. "We're concerned about deteriorating balance sheets and the slowing economy in the future," says PIMCO's Hague. With these debt levels and at these interest rates, Old Economy corporate issuers don't have a lot of room to maneuver. And that could make any slowdown considerably worse.
Copyright 2000 , by The McGraw-Hill Companies Inc. All rights reserved.
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