If you want evidence of the Federal Reserve's power to arrest an economic slowdown, look no further than the corporate bond market. The Fed's rate cuts have allowed corporations to begin repairing their balance sheets, cutting their borrowing costs, and raising funds for expansion.
Corporations are borrowing on a massive scale. They have sold more than $291 billion of bonds in the U.S. so far this year, compared with $187 billion at this time last year, according to Thomson Financial Securities Data. Excluding junk bonds, which were still strong in early 2000 in the last days of the stock market boom, the turnaround is even more dramatic: $212 billion this year vs. $63 billion last year, according to Merrill Lynch & Co. At this rate, the market will have bought as much investment-grade debt by July as it did in all of 2000, a record year itself.
The corporate-debt market was comatose before Fed Chairman Alan Greenspan and fellow governors made the first of five half-point rate cuts on Jan. 3. Now the market is stronger than ever. "Nobody would have foreseen this, even considering the benefit of Mr. Greenspan," says Peter Milhaupt, a managing director and co-head of Credit Suisse First Boston's U.S. debt-underwriting section. Investors swallowed $40 billion of new corporate bonds in the first two weeks of May with barely a burp. Amid the offerings, interest-yield spreads over Treasuries increased only 0.05 percentage points. "It is amazing. There's been very little indigestion," says Mary Rooney, a bond strategist at Merrill.
BIG DROP. The market revival is a boon to business. For one, companies are reducing their interest expense. Market interest rates on 10-year, single-A debt are generally down about 100 basis points, to 6.5% from last year, says Dennis Adler, a bond strategist at Salomon Smith Barney Holdings Inc. More important, about half of the new debt is being used to pay off commercial paper, which matures every few weeks. That makes companies less vulnerable to sudden problems in the commercial paper market, like the ones that hit when California utilities faltered. By extending the debt a few years, companies lock in time to deal with problems in their own business. They build in the kind of cushion Lucent Technologies Inc. craved earlier this year when it was scrambling to replace its commercial paper and avoid a liquidity crunch.
In a dramatic illustration of how this exceptional market is working, WorldCom Inc. sold $11.8 billion of debt on May 9. The offering was the biggest ever by a U.S.-based corporation and echoed giant issues earlier this year by France Télécom (FTE
) and AT&T Wireless (AWE
). Larger issues are selling best because institutional investors believe the bonds will be easier to trade if the market falters. WorldCom (WCOM
) originally expected to sell about $7 billion of debt now and $5 billion more later, but found the market strong enough to fund all of its needs right now.
Half of WorldCom's proceeds are going to pay off its commercial paper. Its paper is rated "second-tier" for creditworthiness and that makes it vulnerable to being suddenly spurned by lenders. An additional fourth of WorldCom's proceeds are going to pay down existing debt. Only one-fourth will be invested in WorldCom's business. The mix is typical of how new issues are being used and suggests the market is not funding a new round of reckless capital spending.
"Companies are basically doing this to clean up their balance sheets," says Richard J. Peterson, a strategist who tracks deals at Thomson Financial. In fact, much of the commercial paper being refinanced in the bond market was originally issued to pay for past telecom capital spending, such as burying fiber-optic cables and building wireless networks. Now telecoms are getting more time to pay.
Other industries are also taking advantage of the market. Recent issuers include DaimlerChrysler (DCX
), Morgan Stanley (MWD
), Ford (F
), Kellogg (K
), Viacom (VIA
), CIT Group (CIT
), and Caterpillar (CAT
). Navistar International Corp. (NAV
) and Target Corp. (TGT
) are expected to come to market soon.
Is the money to buy the new issues coming out of the stock market? Not much. Most is coming from interest payments and from the federal government's retirement of Treasury debt. A big reason bond investors are buying the issues is that they've become more confident the Fed rate cuts will keep the economy out of recession. "They're spurring people's appetites to take credit risk," says John Bender, portfolio manager of the Strong Corporate Bond Fund. Two institutional investors recently changed their investment strategies and bought a combined 15% of DaimlerChrysler's $2 billion issue in early May, says Milhaupt of CSFB, one of the underwriters. The investments reflect new confidence in the cyclical auto industry and the belief that yields on corporate bonds are worth the risk.
Bender bought new WorldCom bonds for their yield. The 30-year debt, rated BBB+, was priced to yield 2.65 points over Treasuries, or 8.42%. That's nearly 1 point higher than comparable debt for AOL Time Warner Inc. (AOL
) and Occidental Petroleum Corp. (OXY
), he says. Sure, the telecom industry has more trouble than media and energy, but "we're getting paid more than enough extra income for the risk," says Bender.
FEW MERGERS. It is unlikely the bond market will stay so hectic, even after the Fed's May 15 half-point cut in interest rates. The amount of "second-tier" commercial paper outstanding has been cut by about one-third already, according to Salomon Smith Barney. Corporations probably won't want to reduce it too much more. Unlike when the Fed was starting to cut short-term rates, borrowing with commercial paper is again becoming significantly cheaper than borrowing long-term. Nor, will as many new bonds be needed to finance mergers: M&A volume is half what it was this time last year, says Peterson. Salomon's Adler expects the torrid pace of new bond issues to slow by one-third in coming months.
But even if it does, 2001 will be a record year in the corporate bond market. Chairman Greenspan, take a bow.
By David Henry in New York
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Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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