What’s Up With Bond Prices and Yields?
An article by New York Institute of Finance fixed income instructor Angelo DeCandia.
Anyone familiar with the Fixed Income markets knows the oft-repeated rubric “yield up, price down, yields down, prices up”. But what causes yields to move up or down? Fed watchers will quickly respond, “It’s monetary policy and macroeconomic variables such as GDP, inflation and unemployment.” Which is true, but less important to investors in lower credit issues. They tend to be more focused on credit variables rather than economic stats.
All of these factors are significant, but they play out in the arena of Fixed Income markets. And like markets for any security, asset or commodity, it is all subject to the vagaries of supply and demand. In other words, bond pricing is as vulnerable to the supply and demand of Fixed Income products as it is to the yield on a 10-year Treasury note or the credit spread on high yield bonds. Given that simple premise, we wonder what roles supply and demand has played in the stubbornly-low yield environment of the past 5 years and if that relationship is about to change.
As I write this, Apple Computer recently completed a $170 billion bond offering, its first since 1996 and according to Bloomberg data the largest bond sale on record. Interestingly it follows a $2 billion offer by tech-rival giant Microsoft just a week prior. The Apple deals offers a variety of fixed and floating-rate issues with yields of 5 bips above 3-month LIBOR on a $1 billion issue and a $2 billion of a 5 year issue spread 25 bips above the same benchmark. Ostensibly, Apple’s motivation is to help finance a multi-billion cash distribution to shareholders to push up its stock price. But sources close to the deal say that borrowing money to finance the payout is a strategy to help avoid re-patriation taxes and the vast amount of cash it has accumulated overseas. But does anyone believe that this would be the preferred way of handling payout policy if rates weren’t so low?
Various studies have documented that U.S. corporations have collectively raised more than a trillion dollars in recent years through debt offerings. Besides the obvious question as to where all of that cash has gone, it also raises the issue of impact on the debt pipeline. Which brings us to the question at hand: With so much debt outstanding (lots of supply), why haven’t prices fallen and consequently put upward pressure on yields?
Even taking into account the most accommodative monetary policy in the Fed’s history (perhaps in any central bank’s history), the normal relationship between supply, prices and yields seems to have grown loose by traditional standards. What are the implications for future prices and yields?
A cursory look at bond issuance in recent years shows that debt security issuance had approached $4 trillion in the lead-up to the crisis of 2007-08, but had fallen to approximately half that by 2011. Moreover, the bulk of the issuance up to 2007 comprised Treasury and MBS/ABS issues, in part fueled by the CDO craze. Corporate issues at that time made up barely 30% of the total. Since then, however, there has been a fall-off in structured issues and a sharp increase in plain old vanilla-style corporate issues resulting in a doubling of new issues in this less complicated sector. So it is reasonable to assume that the addition of all this supply, due to investor’s fees of complicated debt structures and a low-yielding environment, should have driven prices down and yields up. But it hasn’t. So perhaps there’s something going on with the demand side.
The relationship of supply and demand is one based on equilibrium. If there is an increase in supply, prices should fall. Unless there is an increase in demand that absorbs the added supply. Well-known bond manager Bill Gross of PIMCO has characterized the current corporate bond market as “exuberantly and irrationally priced”, an indication that investors are more enthusiastic for bonds then they should be. So we must consider the demand side as well, something we will do in a future posting. For now we will leave it at this: What we really should be analyzing is the net difference in supply and demand, because that is what will tip bond prices and yields one way or another.
In summary, the closer we look the more we realize that supply and demand dynamics are very complex. It almost makes us want to apologize for ever having complained about the tediousness of present value calculations when pricing bonds. If only it were as simple as a straight-forward quant calculation…
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