When we earlier discussed the unwillingness of institutional investors to return to the market even as retail investors swing from one mood extreme to another, we showed a chart showing the historical and seemingly relentless selling by virtually every investor class in the past decade, which left just one question for traders: when do the stock buybacks finally stop and put an end to the party?
Answering that question would also require the response to another, far bigger question: when does the bond market stall out, or in other words, when does the endless demand for yield finally fizzle out?
For anyone to claim they have the definitive answer would be folly: after all there have been so many prior occasions in which analysts and pundits declared the end of the all consuming bond bid, only to be mocked by investors gorging on even more corporate debt. And yet based on recent bond sales, it appears that finally investors may be getting full.
But how is that possible? Just two weeks ago there was an unprecedented $100 billion in bids for CVS's gargantuan 9-part $40 billion IG deal?
Well, as Bloomberg reported recently, in a first indication that the saturation point is approaching, there have been far fewer orders coming in for new bonds, relative to what’s for sale. This has resulted in bond-selling companies paying more interest compared with their other debt, according to Bloomberg data, and once the securities start trading, prices have been falling on more than 50% of new issues, an indication that "flipping" bonds for a profit is now only profitable half the time. And flipping for a profit, or loss - as any bond trader knows - is a well-known leading indicator to the overall strength of the bond market.
This, as Bloomberg notes, is also the latest signal following weeks of declining inflows and even occasional fund outflows, that the IG debt market is losing steam and may be approaching its tipping point after years of torrid gains, amid concerns about rising rates and talk of tariffs weighing on corporate profits.
“Investors are starting to be a little more disciplined,” said Neuberger Berman PM Bob Summers. "They aren’t just waving in every deal now."
To be sure, investors' restraint amounts to more pain for companies. As we showed recently (see chart below) the average yield on corporate bonds is around its highest levels since January 2012, according to Bloomberg Barclays index data. Even with the previously discussed CVS Health’s $40 billion blockbuster issue last week, sales volume for new investment-grade corporate debt is at its lowest level so far this year since 2014.
Meanwhile, it has been a decidedly mixed picture in terms of fund flows, as reduced inflows and occasional outflows from mutual funds and exchange-traded funds have indicated that investors may need some time to digest the pipeline, or as Yuri Seliger, a credit strategist at Bank of America Corp, said "the negatives are winning out right now."
To demonstrate that credit finds itself at a sensitive junction, Bloomberg provides the example of Campbell Soup, which sold $5.3 billion of bonds this week to fund its planned acquisition of Snyder’s-Lance Inc.
Typically, bankers start selling the deal to investors at a relatively high yield compared with Treasuries, which they decrease as demand increases. In this case for the biggest parts of the deal, they never did, and the bonds weakened relative to Treasuries after they were sold.
Then there is the oversubscription problem, or rather lack thereof: while companies - in credit boom times - get orders for three or four times as many bonds as are for sale, at the beginning of the week order books were barely two times covered. As a result, borrowers paid yields that were an average of 0.11 percentage points higher on new deals compared with their existing securities last week, a new issue concession much higher than the 0.013 percentage point-average for the year. And - as shown above - yields relative to Treasuries weakened on more than half of new issues on Monday and Tuesday, a recent BofA analysis revealed.
To be sure, for now the credit weakness is issuer specific - one would have to look hard to find a problem with McDonald’s sale of $1.5 billion of bonds last Wednesday, in a deal that was 4x oversubscribed, and then cut yields on all three tranches relative to price talk; post-break, spreads on all three parts narrowed as of Thursday’s close in New York.
Meanwhile, as the increasingly tentative market waits to find out how this period of uncertainty ends, some investors are pitching the recent weakness as a buying opportunity largely thanks to ongoing strong cash flow, helped by tax cuts; investors such as Tom Murphy, head of investment-grade credit at Columbia Threadneedle Investments.
“If fundamentals are unchanged and spreads are wider, shame on us if we’re not buying securities,” Murphy said. “You’re supposed to start taking some bites of the apple here.”
That may not last long though, as fundamentals are starting to shift with the Fed expected to lift rates three (or more) times this year, retail sales falling for third straight month, amid a near contraction in consumer credit growth.
Of course, any slowdown in corporate bond purchases would come after years of surging demand; as we have documented previously, the market value of investment-grade bonds has more than doubled over the last 10 years, as investors have snapped up new debt, while the economy has grown by about a third.
And, going back to the start of the article, this has also allowed companies to issue virtually unlimited amounts of bonds whose proceeds would be used for buybacks. However, should the IG bond market suffer an even moderate hangover, that may not last. For one thing, the incremental yield on equities relative to bonds has shrunk to the lowest level since 2010.
This in itself could put a significant damped on buybacks. But, more importantly, should the credit weakness spread from the IG sector to high yield, then from a blessing, buybacks may suddenly become a corporate curse as the market mood suddenly shifts, and starts viewing excess leverage as a potential source of instability in a time of rising rates, something we discussed extensively in "Day Of Reckoning" Nears As Goldman Projects A Record $650BN In Stock Buybacks."
To be sure, it is still early to declare the corporate bond market dead or even comatose, although the leading indicators certainly suggest that a hangover has arrived. For what happens next keep a close eye on the market reaction when the Fed hikes rates on Wednesday, and focus not on stocks but bonds - any further blow out in spread, and certainly yields, will mean that - for the time being at least - the bond issuance window is slamming shut; the (buyback) consequences for stocks may be severe.