Corporate Bond Offerings: A Source of Dollar Demand in 2006

We have generally played down the significance of the tax holiday given to US corporations for repatriating offshore earnings in explaining the US dollar’s rally in 2005. For a number of risk-management reasons, US companies tend to keep the vast majority of their overseas earnings in dollar-denominated instruments. Nevertheless, because the law is based on a company’s fiscal year and not the calendar year, there could still be some repatriaiton in the first part of 2006. However, there is likely to be another source of demand for dollars and that is likely to come from a flood of new debt issuance by US companies.

When the US Treasury reports monthly portfolio flows, the market tends to quickly look at the headline figure, but tends to focus on the foreign purchases of US Treasuries. This may be understandable given that foreign investors own around half of all US Treasury instruments. However, what often is overlooked or under-appreciated is that foreign private investors have demonstrated a healthy appetite for US corporate bonds, even as the spreads over Treasuries narrowed and interest in corporate stocks was lukewarm.

In the first ten months of 2005, on a net basis foreign investors purchased around $311 billion of corporate bonds. This accounted for 40.6% of net portfolio inflows into the US. For a comparable period in 2004, foreign investors bought $242.4 billion worth of US corporate bonds, which accounted for about 39.6% of total portfolio inflows as reported by the US Treasury.

According to Bloomberg data, there is a record $574 billion of US corporate bonds maturing in 2006. As companies seek to refinance this debt, they will likely issue a record amount of new debt. The record was set in 2001 when corporate America issued about $676 billion of debt. In 2005, corporates issued $667 billion worth of debt. The first quarter looks to be exceptionally busy. According to some reports, there are at least 89 issues of over $500 mln each maturing in Q1 06, up 20% from Q1 05.

Although the refinancing efforts will likely account for the bulk of the new issuance, financing for mergers and acquisitions and leveraged buy-outs will also boost corporate bond supply. A survey by the Securities Industry Association found that global M&A and leveraged buyouts are expected to rise 15-20% in 2006 over the roughly $2.55 trillion in deals in 2005, which itself represented a 30% rise over 2004.

The yield that investment grade corporate bonds offer over Treasuries is around 100 basis points, which is about half of what it was five years ago. The spread compression is partly a reflection of the continued strong economic conditions (e.g. 10 consecutive quarters with growth in excess of 3% and the prospect that this streak continues) and low default rates. Moody’s estimates that the global default rate for corporate bonds is about 1.8%, the lowest in eight years. The default rate has averaged 5% over the past 22 years.

Counter-intuitively, despite the fact that the Federal Reserve has raised the Fed funds target 13 times since June 2004, many corporations who will refinance maturing debt will actually save money. Industry data suggests that more than 25% of the debt that will mature this year issued in 2001. The average yield of investment grade 5-year notes then was a little more than 7.3%. The yield now stands nearer 5.5%. This means that if all of the $153 billion of maturing 5-year notes were simply replaced with new 5-year notes, corporate America would save around $3 billion annually in interest rate expenses.

For sure, corporations cannot save money on all their refinancing operations. For example, Bloomberg data suggests that $88 billion of 3-year notes issued in 2003 will mature this year and it will be difficult for corporations to roll it over at lower rates. According to Merrill Lynch indices, investment grade 3-year yields fell to record low rates in 2003 near 3.85%. Even the US government cannot raise three-year money that cheaply now.

Foreign investors did not appear to have as strong of an appetite for US corporate bonds in the 2001-2003 period. During those years, corporate bonds accounted for less than 38% of foreign purchases of US financial assets. On balance then, foreign investors probably will be net buyers of US corporate bonds despite the heavy redemption schedule.

Moreover, the shape of the US yield curve denies international investors with a financial incentive to hedge the currency risk on US debt purchases. Although much attention has been paid to the inversion of the 2-10-year yield curve, it might not be the salient one for foreign investors. Typically, asset managers will buy a long bond and use a three or six month forward contract to hedge the currency risk. The spread between US 10-year bonds and three and six month yields (the approximate cost of a hedge for that duration) has narrowed to 41 and 18 basis points respectively. Essentially, this illustrates that due to the flatness of the US yield curve, in the process of hedging the currency risk, foreign investors would be sacrificing the bulk of the yield associated with buying a US bond. It also sheds light on why several Japanese life insurance companies have indicated a greater desire to buy US bonds on an unhedged basis.

Nevertheless, the refinancing of maturing bonds can be expected to strengthen corporate American’s balance sheet. Therefore, in addition to providing foreign investors with more of the instruments that they have demonstrated a healthy appetite for, to the extent that debt servicing costs can be reduced, the strengthened financial position may also attract foreign investors to the US equity market that broadly under-performed the other major bourses in 2005.

The foreign appetite for US equities already appears to have improved. According to US Treasury figures, foreign investors bought almost $75 billion of US shares in the first ten months of 2005. This is more than the $60 billion equity foreigners purchased in the first ten months of 2002, 2003 and 2004 combined.