During the past month global bond markets have, for lack of a better word, shit the bed. The German bund future has given up 9 big figures in a sickening swoosh lower.
The US long bond future has sagged to the tune of 13 handles.
Almost no bond market has been spared.
Market commentators have assigned a whole host of different reasons for the bond decline. From worries about the coming Fed tightening cycle to the possibility of an early exit from the ECB’s QE program, the excuses flung around have been varied, but mostly inaccurate. The problem is most commentators focus on only one side of the equation. They try to explain all price movements through changes in demand, completely ignoring the supply side.
Although I will acknowledge weak demand has contributed to the recent selloff, I believe an increased supply was a much more important factor. During the past month, corporate issuers have floated new bond issues faster than Lindsay Lohan hoovers up her girlfriend’s nightly drug stash. Every day has seen a tsunami of issuers come to market. Headlines like this one from Bloomberg constantly scroll across the tape:
(Bloomberg) — Apple launched an $8b 7-part debt offering for capital return program and other general corporate purposes; deal ranks as 7th largest U.S. investment-grade offering YTD along with Merck’s sale in Feb. and Exxon’s in March.
Yesterday was typical with something like $18 billion of investment grade debt being floated.
You might be saying to yourself, “fine but that is corporate bond issuance, not sovereign debt. Why are government bonds falling?” To a large degree, fixed income is all interchangeable. Yes, there is movement within the spreads between all the different classes of fixed income, but heavy corporate issuance will cause government bonds to fall as investors substitute risk free bonds for riskier ones.
I believe the recent bond decline is the result of a massive increase in bond issuance. It was most likely helped along with a change in inflation expectations (especially in Europe) which caused demand for long dated fixed income to fall (and steepened the yield curve), but the supply side is the key part of the story most investors are underestimating.
What does increased supply mean for the economy?
In a regular economic environment a massive increase in corporate bond issuance would be hugely bullish for the economy. Corporations would issue debt, invest in their business with the purchase of plant, equipment and the hiring of more workers, which would create a self reinforcing cycle. The increase in credit would cause economic activity, which would further fuel confidence from other businesses to do the same, which would continue until the economy heated up to the point where the Federal Reserve felt it had to increase the price of credit by raising interest rates.
This heavy corporate issuance is therefore the end result of Central Banks’ easy monetary policy. Although Central Bankers might mouth some words of caution about the frothy corporate bond market, they are being facetious. This expansion of credit is exactly what they have been hoping would happen.
The problem lies with what the corporate issuers are doing with the proceeds of the debt sales. If they are using the money for business expansion, then we can expect the economy to start humming along nicely in the coming quarters. However, if the majority of the funds are being used to fund equity buy backs, well then, Houston – we have a problem.
If you knew what the money is being raised for, it would be a lot easier
Issuing debt to buy back equity is more of a balance sheet transaction than a true expansion of credit. It is not really fuelling the economy, but merely rearranging the risk profile of corporate balance sheets. Like most aspects of economics, that statement is not entirely true as you could argue equity buy backs allow equity sales from business owners that would then fuel the economy. In reality this trickle down effect is severely more muted than economists believe as most equity is owned by the 0.01%’ers and any increase in their wealth does not alter their spending behaviour.
Therefore determining the reasons for the heavy corporate debt issuance is the key to forecasting future economic activity. If we knew debt sales were being mostly used to fund equity buy backs, then I would be much less optimistic about the chances for an economic uptick in the coming quarters. On the other hand, if these debt sales are the result of companies finally gaining enough optimism to expand their business, then the picture would be completely different.
I don’t have the answer to the question of how much debt issuance is being used for equity buy backs and how much is being used for true capex expansion. The reality is no one really knows. There can be no doubt that equity buybacks have taken the lion’s share over the past few years. But the rate at which corporate issuers have been selling debt, makes me hopeful it is so big that it can’t just be one huge balance sheet arb. Surely all this money can’t be simply going from the bond market into the equity market? God help us if that is the case.
For now I am going to assume the increased debt issuance is the start of a self reinforcing credit creation cycle. Even if there is a lot of equity buyback money being raised, there has to be some capex spending within this avalanche of issuance.
Keep selling rallies
You can keep selling rallies in the bond market. As this credit expansion becomes more obvious to market participants, it will only encourage more bond issuance. We have entered into a multi year bond bear market. The mistake will be getting bullish too early, not the other way round.
Thanks for reading,