Surge in new bond issues threatens to overload fragile bond market

Posted on 06 January 2011 with 1 comment from readers

There has been a big surge in bond issuance by companies on both sides of the Atlantic in a bid to secure low-cost funding before interest rates start to move up.

Such a mountain of new paper threatens to hasten the demise of the bond market with a flood of new bonds, all competing for the same buyers. Greater supply meeting limited demand equals lower bond prices.

Higher interest rates

And for the bond market that also means higher interest rates, for as bond prices fall, interest rates go up – a simple formula that some buyers appear to get wrong or not to appreciate.

Warren Buffett got the first corporate bond issue of the year away on Monday with a $1.5 billion bond from Berkshire Hathaway, followed on Tuesday by Met Life and General Electric Capital.

Deutsche Bank sold $1 billion of five-year bonds in its first dollar-denominated sale since March, while Rabobank issued $2.75 billion of bonds. The feeling among corporates is that it can only get harder to raise money as the year progresses.

The 15 developed nations have to borrow the equivalent of 27 per cent of their combined GDP in 2011, according to reliable estimates. So the public and private sector are going to be competing for the same pool of investor cash.

The obvious caveat is that this is all pretty self-defeating for those who buy the bonds. Those who buy early will be the biggest losers as bond prices weaken as more and more paper is issued by corporates and governments.

Why then are investors prepared to buy bonds paying miserably low interest rates when they can see inflation taking off all over the world as last year’s commodity price hikes are passed on to consumers, and VAT rises are used as an excuse to raise list prices?

Financial suicide

Investment gurus like Marc Faber think buying bonds is suicidal this year. Indeed, some commentators see this as an argument for rotating cash into equities and not bonds. However, by many yardsticks equities look overvalued, and only look cheap by comparison to bond yields.

As bond yields rise, and bond prices fall, therefore equities look less and not more attractive. In fact, a falling bond market will almost certainly take the stock market down with it. For the only way for dividend yields to rise to compete with higher bond yields is for share prices to come down, unless you think profits can be increased with inflation squeezing margins.

2011 is the year when everybody wants to raise money cheaply, and only the early birds will get these worms that will then be eaten alive.