Demand For Bonds Remains High

9/20/2010


Investors are still buying tickets for a long-running show: corporate debt. Bond funds have attracted more money than stock funds in each of the last 30 months, a stretch during which the S&P 500 Index slumped 29%.

Many investors are desperate for shelter after getting soaked by the stock market’s wild gyrations. At the same time, companies are eager to lock in historically low interest rates on loans that won’t come due for three, 10, or in some cases even 100 years.

IBM ($129; IBM) and Johnson & Johnson ($61; JNJ) found buyers for bonds that yielded less than their stock at the time of issuance. Essentially, debt investors are betting that the prices of some of the largest stocks will fall over the life of their bonds. The Dow Jones Industrial Average yields 2.67%, nearly equal to the 10-year Treasury bond yield of 2.74%.

While corporate-bond yields are below long-run averages, their yield advantage over Treasury bonds is relatively attractive. The spread between Baa-rated bonds and 10-year Treasury notes is 2.96%, modestly above the five-year average of 2.76% and well above the average of 1.81% since 1954. However, spreads are down sharply from levels seen in late 2008 and early 2009, when investors fled to the safety of Treasurys.

In the two days following Labor Day weekend, U.S. corporations issued $51 billion in debt. For their part, equity investors wonder how companies will use that money. After all, many companies are already flush with cash, yet remain reluctant to hire or make capital investments.

Some companies are choosing to enrich their investors. In August, DirecTV ($41; DTV) sold $3 billion of debt, planning to use some of that money to buy back stock. Microsoft ($25; MSFT), which issued its first debt in May 2009, sold another $1.15 billion in June and reportedly plans to dip further into the debt pool to fund dividends and repurchases. For other companies, debt helps keep the war chest full. Earlier this month, Hewlett-Packard ($39; HPQ) issued $3 billion of bonds, presumably to fund its recent acquisition binge.

Buyers of corporate bonds walk a narrow and possibly treacherous path. Should the recovery gain steam, consumers could pick up their spending, and the resultant increase in demand for money could drive interest rates higher. And if the economy moves the other way, a double-dip recession could spark an increase in default rates, which in turn would pressure corporate-bond prices.

Several of corporate America’s heaviest hitters have weighed in on the bullish side. Warren Buffett, chairman of Berkshire Hathaway ($83; BRKb), and the leaders of General Electric ($16; GE) and Microsoft expressed optimism about the U.S. outlook at an economic-development summit in Montana. “I am a huge bull on this country,” Buffett said. “We are not going to have a double-dip recession at all.” Meanwhile, the chief investment banker at Bank of America said the U.S. stood a 25% chance of sliding into a double-dip recession, and only in the event of a huge, negative shock.

History tells us that bonds have been less volatile than stocks, and fixed-income securities play an important role in the asset-allocation process. But history also teaches that at the moment when everyone is rushing for a seat in a theater, it might be best to reserve a spot near the exit.


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