August 2020
As we close out summer and the final month of the third quarter, the bond market has been relatively stable compared to the bipolar volatility of the stock market. Earlier this month, stocks suffered an unexpected downdraft after rising steadily from the March low. Speculation is that a sizeable Asian-based hedge fund had bought call options on a number of the largest tech equities. To hedge the sale, the counterparties bought the underlying stocks and inadvertently created a virtuous circle of buying. Once the hedging was complete, sellers stepped in to take advantage of the unexpectedly attractive prices. While difficult to quantify the size of the trading, judging by the run up in stock prices and measures of option value, there seems to some inkling of truth to the theory.
What’s certain is that the bond market has been relatively range bound. The yield-to-maturity on the 10-year note has traded between 0.80% and 0.50%, while the 30-year bond has fluctuated between 1.50% and 1.25%. We get the sense that traders would like to see interest rate move higher, but the Fed bond buying program is keeping that from happening. The Fed continues to plow $80 billion per month into the secondary market for Treasury bills, notes, and bonds. In addition, they have also been buying corporate notes both directly and through Exchange Traded Funds. However, they’ve been buying the latter at a much smaller pace, and over the last month they haven’t bought at all. While they may have paused the program, we suspect that they will put it back to work when the stock market suffers from the next meaningful swoon. As in the most recent episode, by supporting corporate bonds, the Fed is able to avoid having panic spread through the capital markets. Although, as with most Fed programs, the action artificially suppresses interest rates on most corporate borrowing including those companies with large cash balances.
Corporate Management is loving the ultra-low interest rates and have been issuing new debt at ridiculously low levels. There are many reasons why the artificially low interest rates are bad policy but one of the most glaring is Apple Inc. In August Apple issued $5.5 Billion in four tranches with maturities ranging from three years to forty years at an average cost of capital of 1.57%. The yield-to-maturity on the three year notes was 0.55%. Apple disclosed that the purpose of the debt was to buy back shares, a common practice among major corporations over the last decade. What’s perplexing is that at the end of the second quarter the cash held on Apple’s balance sheet totaled $193 billion. It’s as though they view the term structure of interest rates as a financial gift that they just can’t refuse.
But Apple is not an isolated instance. Year-to-date, corporate bond issuance totaled more than $1.9 trillion, more than last year’s total issuance, with much of that coming over the summer. We expect that issuance will continue as the quarter comes to an end and into earnings season. However, there really is no rush to issue debt as the members of the Open Market Committee have all but explicitly said that they intend to keep the overnight rate at the current level for years and have threatened to impose yield curve controls should long maturity interest rates rise.
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