US Inc plays on caution to issue corporate bonds

Some of the biggest industrial companies in the US are rushing to take advantage of soaring investor demand for corporate debt, with a flood of new issuance expected in coming weeks.

Even as the yield on US shares rises to its highest in nearly 30 years relative to investment grade bonds and makes equities look cheap by comparison, the evidence in financial markets is that investors are favouring corporate debt over shares.

Growing uncertainty over the global economy, which has sent stock markets tumbling since late April and contributed to increased volatility, has persuaded many investors that corporate debt is a safer, more attractive alternative to holding equities.

As the earnings season has got under way, a string of blue-chip names has responded by issuing bonds. Alcoa, the aluminium maker, and Kimberly Clark were among the US companies borrowing money on Monday.

This increase in activity is set to make July an important month for the US corporate bond markets. The value of new bonds sold will exceed the value of bonds that are expiring and reverse the trend of previous months.

Barclays Capital expects net new supply by companies with investment grade ratings to be $25 billion in July. In June it was a negative $20 billion, while in May the market shrank by $27 billion and in April just $2.5 billion of net new debt was sold.

Justin D'Ercole, head of Americas investment grade syndicate at Barclays Capital said: "April, May and June were really volatile, and borrowers did not need to step in and issue debt".

The shrinkage of the corporate market in May and June did not, however, reflect a lack of investor demand for corporate bonds. Indeed, investor appetite for bonds offering some pick-up relative to record low US Treasury debt has been on the rise.

Fears of a looming double-dip recession have been the main driver pushing investors to seek the relative safety of bonds, particularly those seen as less risky and carrying investment grade credit ratings.

Also, expectations that central banks in the US and Europe will keep interest rates at historically lower levels than was thought only a few months ago has increased the allure of holding debt. Moreover, investors holding debt rank higher than shareholders should a company collapse.

Mark Kiesel, global head of corporate bond portfolio management at Pimco, said: "The asset allocation is moving up the capital structure. We see a lot of demand from clients around the world for high quality investments."

The jitters about the global recovery and concern about the possibility of deflation in the US and Europe have pushed yields on US Treasuries, considered the safest form of debt, to historic lows. On Monday, the yield on 10-year Treasuries was at just over three per cent.

These extremely low borrowing costs for governments have fed through to all-time low borrowing costs for companies considered to be creditworthy.

According to Barclays Capital, the yield paid on US corporate bonds over the last 20 years was on average 6.6 per cent. Now, the yield is at 4.07 per cent — far below that average. That has made issuing debt all the more attractive for big US companies.

Even lower Treasury yields, and expectations that inflation will remain low, have encouraged investors to put their money in corporate debt, too.

In contrast to the corporate bond markets, where net supply can be negative, there is no shortage of debt sales by governments, some funding record deficits.

Kiesel said: "The creditworthiness of governments is being questioned as they take on more debt from the deleveraging of the private sector.

"Companies are hoarding cash, so the outlook for corporate bonds is good."

The demand for corporate debt comes even as some measures show US equities are at their most attractive relative to corporate bonds in decades.

Stuart Schweitzer, global markets strategist at JPMorgan Asset Management, said: "Equities, based on the risk premium relative to corporate bonds, are historically cheap".

After a rally that began in March 2009, US stock prices peaked in April before correcting nearly 20 per cent. Since that peak, however, company earnings have been robust and are projected to stay so. That earnings strength is in large part what makes equities look cheap by comparison.

Indeed, the yield on shares, as calculated by expected dividend returns by JPMorgan, is at its highest versus investment-grade corporate bond yields since at least 1982.

This spread, referred to as the equity risk premium, is about four per cent. It last peaked at the 2009 post-crisis market bottom, at about 3.5 per cent.

A similar finding holds when considering trailing earnings instead of future cash flow, which relies on forecasts by companies and analysts.

By that measure, Citigroup Global Markets calculates that stocks are yielding more than corporate bonds, only the fourth time since 1985 that stocks have yielded more than bonds, and by their widest margin.

The spread reached its highest point on July 3, when the S&P 500, valued by the trailing four quarters of earnings, was yielding about 100 bp more than the average Baa-rated corporate bond, the lowest investment grade rating, according to Citigroup Global Markets.