By
Jeffrey Rosen
:
Last week, The Wall Street Journal reported that bond yields of
Exxon Mobil (
XOM
) and Johnson & Johnson (
JNJ
) were trading below Treasuries. In effect, investors feel that
these AAA-rated companies are more secure than U.S. government
debt. Exxon and Johnson & Johnson may not be alone for much
longer.
Over the past several months, corporate bond yields across the
investment spectrum have fallen precipitously, as investment firms
have increasingly allocated more into the corporate bond space in
search of higher yield.
The concern is that the drop in yields, especially when they
fall below comparable Treasuries, is a sign of a bubble ballooning
in corporate bonds.
Fortunately, the data suggest the drop in yield is due to normal
market functions, and not a bubble. That is good news for
investment grade bond funds such as Fidelity (
FBNDX
), PIMCO (
PBDAX
), and Wells Fargo (
WTRZX
) and for insurance companies that hold large amounts of corporate
debt like MetLife (MET), Prudential Financial (PRU), Manulife
Financial (MFC), American International Group (AIG) and Hartford
Life (HIG).
(click to enlarge)
Not a Supply Issue
Typically, such a sharp drop in yields would be a reflection of
high demand chasing low supply. Yet, corporations have actually
been fueling the demand by issuing more debt.
(click to enlarge)
Corporate issuance is currently running 20% higher,
year-to-date, in 2012 than in 2011. That has led nearly to more
volume through September 2012 than what was issued for all of
2011.
(click to enlarge)
The drastic increase in bond issuance is not a result of a poor
yearly comparables. Total volume in 2011 was only slightly below
that in 2010 (-4.8%) and was in-line with pre-recession levels.
Assuming that current trends continue for the rest of the year,
total bond issuance in 2012 will surpass $1.216 tln, which is 7.9%
higher than the record peak in 2007.
Is it a Bubble?
With the extreme amount of debt issuance coupled with low
yields, the corporate bond market has all the signs of a bubble in
the making. Yet, the fundamentals behind the yields are not
necessarily out of line with current economic conditions.
With the exception of AAA-rated corporate bonds -- which likely
suffer from supply shortages that artificially shrink credit
spreads - 10-year corporate bond spreads to comparable Treasuries
remain above their pre-recession levels. This is indicative that
bond investors believe the default risks are relatively higher
today than they were in 2007.
It is possible that, even though spreads are above pre-recession
levels, investors are underestimating the risk of a default. The
underlying economic trends, however, do not point to a sudden
increase in defaults anytime soon.
Macroeconomic Fundamentals
(click to enlarge)
The Chicago Fed National Activity Index -- a measure of current
economic conditions that accurately project recessions -- is below
0. However, that only means that the economy is not currently
growing at the historical trend (3.0%), which the last several GDP
reports have already confirmed.
When the index falls below -0.7, a recession is imminent. The
underlying economic conditions are currently well above that
level.
The latest consensus GDP projections from the Q4 2012
Philadelphia Fed's Survey of Professional Forecasters also show no
sign of economic weakness. The Conference Board's Leading
Indicators Index confirms these results.
(click to enlarge)
Furthermore, the drop in yields is not a result of concerns
about financial liquidity. Both the Kansas City and St. Louis
Federal Reserve Stress Indices are below 0, which implies that
financial stress is currently less than this historical trend.
That means that investors are not seeking corporate bonds in an
effort to maintain liquidity in lieu of investing in other
fixed-income assets. Financial constraints are not causing the
safe-haven status of corporate bonds nor are they artificially
depressing corporate yields.
Conclusion
Corporate bond yields have fallen significantly over the past
few months, even as bond issuance has spiked. Normally, these
factors suggest a developing asset bubble in the corporate bond
market.
Yet, the underlying data do not point toward a bubble. Instead,
the data provide solid evidence that the drop in yields is due to
normal macroeconomic fundamentals.
Corporate bond spreads to Treasuries remain above pre-recession
levels. Investors are not pricing in extraordinary low -- or bubble
level -- default risks. In fact, the assumed default risk is
in-line with current macroeconomic factors and expectations. These
factors suggest that corporate bonds are not currently in a
bubble.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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