Here Come the Bonds

This week kicked off the much-anticipated surge in bond issuance on both the government and corporate fronts. How the market responds will have implications not only for bondholders, but also for the economy and the stock market.

The Treasury Side

Since Sept. 11, most analysts believe that the surplus for the coming year has shrunk from $150 billion to zero. The knee-jerk reaction I've seen in most of the press is that bond yields will go up in response to this amount of new issuance.

Bonds are getting little help from professional bond investors, who have remained reluctant all year to take bond yields lower on worries that the economy will come roaring back from the easy posture of the Federal Reserve. Ten-year yields are only down about 10 to 15 basis points from Sept. 10, and the tremendous increase in mortgage refinancings in response to the modest decline in mortgage rates has bond investors concerned about a surge in consumption (a la 1998) that could more than offset the drop in air travel.

But the view that yields must go up in response to higher issuance ignores the potential for increased demand from retail investors. Since mid-September, many of my contacts have reported more interest in bonds among retail investors. So far, this has only translated into modest bond-fund sales. If people do re-evaluate their holdings (especially when they start seeing 1% handles on their money funds in a few months) and switch some money to bonds, yields might actually fall.

Of course, if stocks keep rising, individuals might lose interest in safer alternatives. If so, then I believe Treasuries are vulnerable -- but some more so than others. The Treasury seems to share my concern that the economy will have a tough time accelerating if long-term rates remain high. (Ten-year Treasuries are only about 30 basis points lower than when the Fed started its 400 basis-point move in January.)

So it looks like the bulk of the new Treasury supply will be in the short and intermediate areas. The Treasury is continuing with buybacks on the long end, while it increased the size of Wednesday's monthly 2-year note auction to $19 billion, up from the $10 billion to $11 billion auctions of this winter.

If this pattern holds, the Treasury could accommodate $80 billion to $100 billion of the $150 billion shortfall in the 2-year notes, with the difference potentially going into bills and 5-year notes. If supply overwhelms demand, short maturities are probably more vulnerable than long maturities, given the steepness of the curve. That's why I have a modest overweight in long Treasuries and a severe underweight in short Treasuries.

The Corporate Sector

Last week, I mentioned that companies were fleeing the commercial paper market and flocking to the bond market to obtain long-term financing. The Ford (F Quote) deal I noted in the Columnist Conversation Monday morning kicked off this latest wave. It turned out to be even larger than expected, coming in at more than $9 billion.

There are a number of reasons why Ford's deal went so well, and why it will be tougher to do deals like this in the months ahead. First, Ford and General Motors (GM Quote) have unmatched experience in surviving downturns (though thriving is another matter). This year looks to be the third-best year ever for car sales, though automakers' profit troubles indicate problems with their cost structures. The same can't be said of many newer companies, especially those that focused on growth at all costs.

Second, issuance had ground to a halt in the bond market after Sept. 11, so bond managers have pent-up demand for large, liquid issues. After this demand has been sated, it'll be tougher to bring deals to market. The corporate bond market remains thin, and a lot of trading capital has left the market. I noted last week how difficult it will be to obtain year-end financing, and I get the sense that dealers will be financing only minimal year-end positions.

Third, at more than 260 basis points over Treasuries, the Ford deal is an attractive piece of paper to bond managers, one that will help them beat their benchmarks over time. In the last 20-plus years, BBB corporate spreads (of which Ford is now one) have only exceeded the 250 basis-point spread three times: in 1980-82, 1987 and post-1998. Each time, an investor who bought then would have done very well over several years. However, in the short run, waiting a few months to buy would've produced even better returns, as each time these spreads went to the 250 basis-point mark, they kept going to more than 300 basis points. There may be more than $75 billion in potential corporate issuance over the next few months. Combined with a tight financing situation, it could be ugly for marginal issuers.

While these deals may look cheap to buyers, they may be costly to issuers. If oil prices hold here, then inflation could trend down to 1% over the next year. If so, the 7.3% yield on the 10-year part of Ford's deal translates into a real rate of more than 6%. Even if inflation goes back to the 2% to 3% area, that is still a real rate of 4% to 5%. Ford, with its large fixed asset base, can afford that. Marginal issuers may not be able to.

So, it looks like the corporate market will be going to tribal council in the next few months, voting on who survives and who doesn't. At current spread levels, I believe corporates make sense for those with a decent time horizon, and I'm still overweighted. Still, I'm not as overweighted as I normally would be at these spread levels -- I'll wait to see if it gets uglier as we approach year-end.