Corporate Bond Yields Are Lower Than They Appear at First Glance

Oil is hitting new highs and the Euro is hitting new lows. In just a few weeks, these two forces have combined to produce a clamoring from many commentators for the to lower rates and keep the economy humming. However, the Fed only sets a target for very short-term interest rates. Yields on longer-term debt are set by the interaction of buyers and sellers in the marketplace (just as stock prices are) and this interplay is already working to bring down the cost of debt that corporations are paying.

A lot of attention has been focused on the extraordinarily wide gap between Treasury rates and corporate bond yields that has arisen due to the transition from massive federal deficits to equally huge surpluses.

Corporate Bond Yields May Seem High Moody's Baa Index yields vs. 10-year Treasuries

Source: Federal Reserve Board of Chicago

As the chart above shows, the spread for Baa corporates (the lowest category of investment-grade bonds) is near its highest level of the last six years. Other than for a period this spring and for the Russian economic crisis of 1998, the current gap is higher than at any other time in recent history.

However, the spread data masks an important fact that few analysts have picked up on: investment-grade corporate bond yields have actually been coming down (junk bonds are another story). Treasury yields have fallen so much since their peak in May that they have pulled corporates down with them -- even as the spread between the two has widened.

Now, the bond market is not homogenous. Companies with the same rating do not all pay the same rate when they borrow. The level depends on a firm's industry and its own future prospects, among other factors. With the flood of corporate issuance of the last few years, bond buyers have become picky, and a number of lesser-quality firms are still unable to borrow at rates that make sense for them. But many high-quality companies can now issue debt at rates not seen since last fall.

Corporate Bond Yields Moody's Seasoned Indices

Source: Federal Reserve Board of Chicago

The benefits of these lower rates will not be immediate, as the rate on a company's old debt is usually fixed. As this debt rolls off (and there will be a lot of it, given how much companies borrowed in advance of Y2K) and is replaced by lower-cost new issues, these companies' earnings should benefit. New borrowings, undertaken at these lower rates, will improve the profitability of future capital investments.

Even more important to a company than the interest rate it pays is the burden of servicing that debt in real terms, after inflation. That's one reason why fixed-income professionals often measure interest rates against inflation: the difference between the nominal rate and inflation is known as the "real" rate. For example, if a company were to issue a bond at 8.25%, and if inflation ran at that rate for the life of the bond, the investor's income would be completely eroded by inflation, and the company would have borrowed money at a real rate of 0%.

In the last year, the year-over-year change in the Consumer Price Index has risen from just over 2.5% to just over 3.5%. Coupled with the decline in bond yields, companies can now borrow at a very low real rate:

But the 'Real Yield,' After CPI, Has Dropped Moody's Baa Seasoned Index over CPI

Source: Federal Reserve Board of Chicago

Again, all companies are not created equal. Some companies will be able to pass on greater than average price hikes. Some, as DuPont's earnings preannouncement last week illustrated, will have difficulty passing them on. ( DuPont said , in effect, that rising oil prices are boosting its costs faster than it can boost revenue). That's where analysis of a company's fundamentals comes into play.

There is also debate as to whether inflation will accelerate or recede from here. The shape of the corporate yield curve -- which is positive now, meaning that yields on short-term bonds are lower than those further out -- suggests that investors are not expecting yields to fall much more. But, right now, the current low level of real yields means that the "hurdle rate" (the projected earnings necessary to make any new projected economically viable) for new investments is much more attractive than it was during the latter part of the 1990s. If I were a corporate CFO and had a decent balance sheet, I'd be looking for ways to capitalize on this environment now.

James Cramer has been musing about how to play cyclical stocks in his columns. This is one group that, typically, has a lot of debt, and one whose members might be able to take advantage of the decline in borrowing costs. Once we get through the preannouncement season and can get a better handle on who hasn't blown up from energy and currency prices, it might be worthwhile to take a look at this sector.

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Brian Reynolds spent 16 years as a fixed-income portfolio manager and economist at an investment management firm in Cambridge, Mass. He currently trades for his own account. At the time of publication, he is long Treasury Index Funds, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes your feedback at [e-mail].