Friday August 13, 2010
Johnson & Johnson sold $1.1 billion of debt at the lowest interest rates on record for 10-year and 30-year securities amid surging investor demand for corporate debt.
The drugmaker, in the first offering by a nonfinancial AAA rated company in 15 months, sold $550 million of 2.95 percent, 10-year notes and the same amount of 4.5 percent, 30-year bonds, according to data compiled by Bloomberg. That’s the lowest coupons for those maturities on record, according to Citigroup Inc. data going back to 1981.
Yesterday we ran Gary Shilling's piece from the Yahoo site. Gary like Dave Rosenberg believes that the thirty year bond will sink to a 3% yield. At some point the thirty year bull market in bonds, higher prices lower yields, will end. That will be the end of deflation. We will need to see more defaults before that happens. By defaults we mean the failure to be able to make good on promises. Six figures civil pensions, junk bonds, car warranties, all sorts of mayhem. And after that point, all the money the FED has sloshed into the economy will start to have a real inflationary impact. And so, one can understand the strategy of borrowing long term at low rates.
Consider the above example. Johnson and Johnson promises to pay 2.95 percent for ten years. Just a few years back such ten year bonds were paying six percent. If rates return to that level, the value of the bond will collapse by about forty percent, say to sixty cents on the dollar. If J and J simply puts the proceeds in the bank, at that point the company can quietly begin buying the bonds back on the market. And in the process pocket the difference between the sales price at 100 % and the re purchase price at 60%. Forty percent on $550 M is hmm, $220 million. Not bad for the Corporate Finance Dept, and at zero risk.
Investors have poured money into corporate and municipal bonds. We suspect many more of those municipal bonds are junk than people realize. If and when rates return to more normal levels. the value of these bonds, like the J and J bonds will be a fraction of their issue price. Like the sub prime borrowers with adjustable rate mortgages, the issuers will then face higher re financing costs as the debt comes due. With lots of nervousmoney tied up in such bond funds. the result will likely be a stampeded out of corporate and municipal debt. It won't be pleasant. Here is how it played out in the 1930s.
investor
The thing that killed stocks in the 1970s was the availability of high interest rates at the FDIC banks. And so, when rates start back up say in 2012, investors see the value of their bond funds drop. Stocks will be dropping to their final 6% yield level on dividends. And it is not hard to imagine investors checking out of both stocks and bonds to the 'safety' of guaranteed 6% bank deposits.
Such an event is a few years off but that is not long. Meanwhile the smart corporations are betting long on low rates. Investors with lots of exposure to long maturities at historic low rates are now at the highest level of bond risk in thirty years. Since a bond fund, the usual choice of retail investors, has no maturity date, it is subject to interest rate fluctuations, with no assurance the current high prices will ever be seen again. To be informed is to be prepared.
Here is a visualization of what we are describing.
The red black bars are the declining rates on the thirty year bond yield. It just dropped below 4%. Gary Shilling has a target of 3% over the next couple of years. The black line is the price of the Franklin Federal Tax Free 'Insured' bond fund. Recall that AMBAC is in bankruptcy and MBIA trades for a fraction of its price a few years back. Those are (were) the primary bond insurers. But we digress...AS rates have fallen investors have scurried into long term bond funds for yield. The yields continue to drop the prices go up, so far so good. But as one can see investors are buying at all time high prices. A reversal in rates will likely reverse bond prices, violently. Few will be prepared for the need to exit, quickly.
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