Did You Miss the Boat?

The bond market boom is over for issuers, right? Not if a company considers the real cost of financing.
Jesse FogartyJuly 18, 2013

It is always remarkable to me when the market gets surprised by something that should have been obvious. Perhaps the market was too busy enjoying the easy money being provided by the Federal Reserve and the seemingly endless climb of risky assets to realize that quantitative easing must end eventually. 

Or, maybe the shock experienced in June was based on something logical, such as a belief that the economy simply is not strong enough for policymakers to consider letting their foot off of the pedal just yet. Whatever the reason, the market was clearly not prepared for the “taper talk” from Federal Reserve Board of Governors’ Chairman Ben Bernanke.

The month of May started off innocently enough. Stocks were booming, with the S&P 500 enjoying a nearly 13 percent rise in the first four months of the year. But the euphoria was not limited to equity markets. Investors poured into the higher-risk segments of the fixed income market as well, with investors seeking yield in a “no yield” world. In the search for income, the average yield on junk bonds broke through 5 percent, a record. The “high yield” market had not exactly been living up to its moniker.

investment grade bond yieldsIn the second quarter, the market began to get a whiff that the punch was going to be watered down. Bernanke’s testimony to the Joint Economic Committee in May began to make traders jittery. By the time of the June Federal Open Market Committee meeting, the Chairman’s comments were viewed as decidedly hawkish. Bernanke acknowledged that the economy maybe, just maybe, had become strong enough to be weaned off the elixir of extraordinarily easy money. The resulting sell-off was not pretty.

The benchmark yield on the 10-year Treasury bond skyrocketed from 1.62 percent (not too far from the all-time lows witnessed last summer) to 2.70 percent, a jump of more than 100 basis points. The robust June employment report added fuel to the fire. The surge in yields caused the Barclays Aggregate, a widely followed fixed income benchmark, to suffer its worst quarterly loss in nearly a decade, causing many to wonder if the 30-year bull market in bonds had finally ended.

Under the wire

The much-hyped $17 billion debt financing by Apple to fund its stock repurchase program now looks impeccably well timed. The April 30 issuance of Apple’s bonds was oversubscribed but in retrospect was just under the wire, before the recent jump in rates. (Maybe if the company can’t maintain its dominant position in the smart phone and tablet markets, it has a future as a hedge fund manager.) As of early July the cost savings for Apple, on a present value basis, was nearly $1 billion, compared with what it would have had to pay if the bonds had been priced following the jump in corporate bond yields. That amounts to more than three years of interest payments at current levels. Not too shabby.

So, the question at hand for corporate treasurers is: “Did I miss the boat”?

While I believe that the lows in the Treasury market have been set and we are unlikely to see a return to the financing levels witnessed just two months ago, the answer for corporate treasurers is an unequivocal “no!” Despite the recent leg higher in rates and the moderate widening in credit spreads, the cost of debt is still very low by historical standards. When a highly rated issuer takes into account the effects of both inflation and the tax benefit of debt, the true cost of debt funding looks to be close to 1 percent. Even after the jump in rates, issuing debt in today’s market can be an effective tool for lowering a company’s overall weighted average cost of capital.

To a large extent, most of the bond issuance conducted over the past couple of years was primarily for the refinancing of maturing debt, financial engineering to fund share repurchases or special dividends to circumvent changes in tax policy. Those in America’s C-suites did a fantastic job navigating and recovering from the “Great Recession” of 2008-2009, quickly adjusting their cost structures to survive lower aggregate global demand. By and large, companies aggressively cut costs and slashed capital expenditures to survive in an uncertain world. 

Being defensive was clearly the right course of action and by focusing on fortifying the balance sheet and maintaining liquidity, many companies are in better shape today than before the crisis. With global economies on the mend (for the most part) and tail risks receding, it may now make sense for executives to adopt more offensive strategies. With the cost of debt still very cheap, companies with a long-term view may be rewarded for taking advantage of central banks’ gift of low rates to reinvest in the future.

All opinions expressed in this article are solely those of the author.   

Jesse L. Fogarty, CFA, FRM, is a managing director at Cutwater Asset Management. He is responsible for investment-grade credit-portfolio management and trading across all managed accounts, with a primary focus on liability-driven investing products.

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