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Monday, September 13, 2010

Who Do You Think Is On The Right Side of This Trade

The financial markets are experiencing a massive exchange of funds between two groups:

Corporate treasurers eyeing the historically low rates for borrowing are issuing debts in record amounts, lowering their cost of capital and building up cash for future business expansion, stock buybacks, paying down higher cost debt or dividends. These corporations are effectively selling massive amounts of bonds into the market

as the wsj notes

Blue-Chip Borrowers Issue Debt in Droves

Companies are jamming the bond market with fresh debt this week, and yield-hungry investors show no sign of blanching—though with each new shovelful the day of saturation grows nearer.
Mark Gongloff discusses the recent eagerness of blue-chip companies to issue fresh debt, and the eagerness of investors to buy it.
An estimated $51 billion in fresh corporate bonds and leveraged loans have hit the market in the past two days, according to estimates by Dealogic and Standard & Poor's Leveraged Commentary & Data Group. Wednesday alone was the busiest issuance day for high-grade bonds this year, with more than $19 billion in new debt, according to Dealogic. This week is on pace to be one of the busiest of the year for corporate debt, despite the number of possible buyers in the market being curtailed by both the Labor Day and Rosh Hashanah holidays.
Corporate borrowers are enjoying a golden moment of super-low interest rates combined with a scramble by global investors for higher-yielding assets, given that cash is yielding nothing and the stock market stalled. Allergan Inc. this week borrowed $650 million at 3.375%, the lowest 10-year yield for a large U.S. corporate bond issue since at least 1995.
The trend has extended to high yield (junk ) debt as well and with the large build up of cash, many companies have actually moved from junk to investment grade status pictured here are the trends in high yield bond spreads and issuance (from the ft)

And who is buying this debt with the record low interest rates effectively on the other side of this trade ? It seems to include masses of individual investors disillusioned with equity returns and anxious to pick up yield above that of treasury bonds. The 2wsj gives the evidence from money flows in the mutual fund world:

Long-term mutual funds had an estimated $4.31 billion of outflows in the latest week, ending a 13-week streak of inflows, as investors pulled money from stock and hybrid funds, according to the Investment Company Institute. Bond funds have thrived, as they typically do in a lower-interest-rate environment, while stock funds have failed to consistently attract new investment for over a year despite 2009's sharp rally. Before the latest outflows, ICI had reported inflows for 13 consecutive weeks, totaling about $50 billion on an unrevised basis and almost entirely due to money going into bond funds.
For the week ended Sept. 1, ICI reported that stock funds had outflows of $9.54 billion, up from $4.6 billion a week earlier. U.S. equities had $7.6 billion pulled from them, while $1.94 billion was withdrawn from foreign funds. Overall, stock funds that ICI tracks last reported weekly inflows in early May.

At the same time, bond funds took in $6.66 billion, up from $5.9 billion the previous week, ICI said. Taxable funds had inflows of $5.66 billion, and municipal funds added $1 billion.
Individual investors plowing money into bond funds with near record low yields or the world's largest corporations making use of that demand to issue long term bonds at those same low interest rates, who do you think is on the right side of the trade ?

I would advise individual investors that instead of following the crowd in the mutual fund flows and  filling the asset side of their balance sheet with low yielding bonds, they follow the lead of the corporate treasurers and look at the liability side of the balance sheet. If there is an opportunity to refinance high interest rate debt  (fixed rate mortgages) or floating rate debt (arms0 with  long term fixed rate debt now is the time to do so. As the corporate treasurers know this is the surest way to improve the balance sheet, improve cash flow and to be well positioned for future opportunities.

a pretty strong case against long term bonds appeared in the ft( my bolds) seems the only reason to hold them is as a momentum trade not an investment

By the standards of the 20th century these are extraordinary figures which, if taken at face value, imply that inflation is not only dead but more or less permanently buried. In the short term they seem to point not just to a double dip recession, but to outright deflation continuing for several years. To purchase and hold to maturity a long-dated US Treasury or UK gilt at today’s yields is a remarkable act of faith in an unproven thesis.
There are of course reasons why owning government bonds today at record low yields can be rationalised. Some investors, we know, are required to own long-dated bonds, whatever the price. With the economic data so uncertain, it is by no means impossible that bond yields could go lower from here, creating the potential for trading gains. Bonds still have a certain amount of diversification value, though how much is open to question, since diversifying assets are only sure to diversify effectively when they are the right side of fair value. Probably the simplest reason though can be summed up as “don’t fight the Fed”....

Yet in the short term, despite the bond market trading at artificially depressed yields, many investors continue to buy the deflation story. There is comfort in numbers. But it is not hard to predict that this trend, however long it still has to run, is not going to end well. Professor Jeremy Siegel of Wharton says that investors who pay 100 times the yield to own a US government bond are participating in a bubble that is every bit as extreme as that involving internet stocks in 2000. Nassim Nicholas Taleb, author of the Black Swan and Fooled By Randomness, says that “every single human being” ought to bet against US Treasuries. It is a “no brainer” of a bet.
It is the nature of climactic moments in markets that warnings tend to count for little when momentum is running strongly in the opposite direction. The Queen was puzzled enough by the global financial crisis to demand to know why nobody apparently saw it coming. Mr Obama won’t be able to say the same about the coming fallout in the bond markets. 

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