You know times are good for corporate bonds when portfolio managers keep less than 1 percent of their funds’ assets in cash.
Such is the case with Vanguard’s Earl McEvoy, who has made a nice living over the years by betting on falling interest rates. As of February 1, his long-term bond fund was the top-performing high-quality corporate bond fund in the US for five, ten and 15 years running, with the fund’s five-year annualized return of 9.7 percent outperforming the peer group average of 5.6 percent. Sure, Vanguard’s infamously low expenses have helped the fund, but not nearly as much as the bull market for corporate bonds.
With interest rates low, global economies humming (with the oft-noted exception of Japan and several other Pacific Tigers), 30-year bond yields drifting below 6 percent, and a flurry of recent acquisitions, it’s boom times in corporates for the first time in years. ‘I think you can get whipsawed when you think short-term,’ says McEvoy, who likes his investors to stick around for five years. ‘But it has been quite a run-up of late.’
His bond brethren agree. ‘The bond market has really been amazing,’ says Harry Resis, a fixed-income fund manager at Scudder-Kemper Investments. ‘I think it’s been a momentum-driven market that’s driving some credits up by eight or nine points – credits that I don’t always think are so great. But in this environment every company has a chance to do well and attract new money.’ Resis cites a strong economy, low interest rates and no signs of inflation as the main drivers of the bond boom: ‘We haven’t seen an economy like this for 35 years.’
Some fund managers think that the good times will continue to roll, with the only significant cloud on the horizon being the Southeast Asian currency mess. ‘The bond market is leaning on a robust economy, but with some deflationary possibilities in Asia. We’re really sitting on the tip of the knife over there,’ says Bill Stevens, a short-term bond fund manager at Montgomery Asset Management who has recently been taking advantage of the lower risk of short-term bonds. ‘The price of going with longer durations is not that prohibitive when compared to short-term rates.’
Coming up roses
The downward spike in long-term bond yields has led to a flood of issuance from corporations worldwide looking to take advantage of the lower rates. According to Securities Data Corp, investment-grade debt in 1997 exceeded 1996 totals by 40 percent, rising to $726 bn. That figure is expected to be surpassed in 1998, if the year’s first quarter is any indicator. According to Eden Riche, head of debt syndication at Morgan Stanley Dean Witter, US corporate bond issuances in January alone exceeded $50 bn, which indicates that this year will smash existing records.
With bond yields on 30-year-Treasurys (the flagpole that all corporate bond issuances are tethered to) at historic lows, corporate bond issuance rates were ranging between 6.2 percent for a company holding a triple-A credit rating and 6.75 percent for the lowest investment grade rated bonds of BAA3, according to Moody’s Investor Services.
Some companies are dipping into the well whether they need the cash or not. Lucent Technologies’ January issuance of $300 mn worth of long-term debt punched in with a yield of 6.45 percent, one of the lowest yields paid for a single-A rated maturity since 1970, company officials say. ‘We actually don’t have a great need for the funding,’ says Meg Walsh, Lucent’s treasurer. ‘We just saw this as a good window of opportunity to take advantage of the low rates.’
Brand names like Norfolk Southern, Raytheon, JC Penney and WorldCom all dipped their toes into the new issuance water in recent months. In one week alone in early January, IBM, Travelers Group, Coca-Cola and a few other blue-chips borrowed more than $11 bn in the bond market. All hammered out new multi-billion issues, which are becoming commonplace occurrences these days. The days of using commercial paper bank loans to finance big capital projects while constantly dribbling out new bonds are history as a roaring stock market, soaring profits and low interest rates make it much easier for companies to place gigantic debt deals.
Norfolk Southern could have financed its joint acquisition of CSX Corp on a shorter-term basis, then termed its debt out gradually, but that would have made the company subject to the vagaries of the market. So the railway giant figured it would do it all in one shot, garnering $4.3 bn in a single spate of new bond issuance (CSX pulled off a $2.5 bn deal of its own earlier in 1997).
Even high-yield bonds are getting into the act. For example, in January, Century Communications floated a $250 mn bond offering of zero-coupon notes, which paid no interest for 10 years. That’s a risky proposition considering zero coupons aren’t exactly the most conservative fixed-income vehicles, but Century pulled it off just the same. Not to be outdone, Ron Perlman at Revlon hatched a $900 mn offering, the highest of its kind so far in 1998, only six months after the Marvel Comics debacle which soured investors.
Convertible bonds are flexing their muscles as well. Some of the largest deals in the bond market recently have come from the convertible bond sector, including February’s $2.4 bn deal by Bell Atlantic to finance its newly acquired 25 percent stake in Telecom Corporation of New Zealand. The tax advantage of the deal shakes out quite nicely for Bell Atlantic, with the company getting the cash up front, but not having to pay taxes until after the bondholders convert their new shares. Demand for the Bell Atlantic convertibles was highest in the US, the UK and Switzerland, where convertibles are strongest, according to officials at SBC Warburg Dillon Read, which handled the deal.
As savvy money managers shift bond assets around the globe in a bid to catch the best yields on the fly, the international bond markets have picked up as well. That’s especially true in Europe, which recently witnessed France, Germany and the UK try with varying success to put their economic houses in order by reducing budget deficits, cutting inflation and generally acting fiscally responsible after several years of benign economic neglect. That austerity has led to a further boom in global bond markets and has prompted some tight bond yields both in the US and abroad, a trend that some bond fund managers expect to continue with Emu right around the corner.
Bond fund managers point out that the likes of Spain, Italy and the Scandinavian countries used to require a lot of individual credit and macro-economic analysis. But with Emu imminent, they are starting to focus on just four large bond markets globally: continental Europe, the UK, the US, and Japan.
That makes it easier for global money managers to move between markets searching for the best yields. And with German bond yields a ‘proxy’ benchmark for Europe – as of early 1998, they were trading at 4.86 percent, the lowest number in years – the spread against Treasurys is a bigger factor than ever and will likely cause some contraction in European bond markets and send even more money across the Atlantic ocean to the US.
Shareholder’s tune
One reason – and it’s a big one – why companies are pulling the trigger now on new long-term debt roll-outs is timing. In the case of Lucent Technologies, debt issuance in January of 1997 would have resulted in the company paying a yield of 7.6 percent annually, compared to the 6.45 percent it paid one year later amid a more favorable market climate. The difference is over $1 mn a year on each $100 mn borrowed. Or in Lucent’s case, over $3 mn per year. ‘Even if we had issued similar debt last November,’ Walsh calculates, ‘it would have added $36 mn in interest expenses over the life of the bond.’
The record low yields the market is producing on long-term debt are feeding the move to constantly create more value for investors. Here’s how it works: companies issue new mountains of debt while buying back shares at a ravenous pace. In a low interest rate climate like the one global economies are currently enjoying, the new issues and stock buy-backs diminish a corporation’s cost of capital, which in turn boosts returns for investors. That’s propelling even more companies to issue new debt.
‘There’s still a lot of cash on the sidelines waiting to be invested,’ says Riche. With bond fund managers like Vanguard’s McEvoy only too happy to put that cash right to work, and heavy-hitters like Norfolk Southern and Lucent Technologies ready to give them the opportunity, the bull is definitely running wild in the global fixed-income sector.
