High Demand for (Low) Yield

Long-time readers are well aware of my call to the end of the thirty-plus year bond bull market in 2012. That’s seven years now behind us. For long-term bonds this period has been quite a topping process (in 2012, 2016 and again in 2019) with the primary result being the tremendous issuance of new debt.

Treasury debt has exploded from $4.3 trillion in 2006 to $15.9 trillion in 2019 (Q2). My debt figures come from a wonderful website, www.sifma.org, check it out.  Luckily the Federal Reserve has been there as the primary buyer, expanding their balance sheet in various quantitative easing programs.

Right behind treasuries in debt expansion is corporate debt, rising from $4.9 in 2006 to $9.5 trillion (Q2). Federal Reserve Chairman Jerome Powell said in October that “leverage among corporations and other forms of business, private businesses, is historically high” –Bloomberg.

Indeed, not only are bond prices high (yields low) but there are more of them! As long as “lower-for-longer” holds, values should hold. Interest rates are low, so low it would appear that negative interest rates are a closer reality than higher interest rates.

So let’s refocus on the trend of the bond market. The past year was largely a correction as yields peaked in December 2018 and moved lower for much of 2019 before bottoming out in September as discussed in last months letter. With the correction over, higher interest rates should ensue with yields surpassing the 2018 highs and marking new territory.

I am taking my cues from the bond market. No market goes straight up or down; it moves in waves and trends form and are corrected. So while others may be transfixed by “lower-for-longer” or “long-bonds-forever,” the entirety of the bond market, particularly shorter-term rates tells me convincingly that interest rates are moving higher.

Some may want a narrative to go with this forecast. One could say inflation will pick up and result in higher interest rates as bonds would be less valuable. I do not believe this will happen as the Federal Reserve has tried to raise inflation for many years, and failed miserably.

A more intriguing narrative may be funding related. This story centers on the recurring subject of repurchase agreements, or repo, that has surfaced these past few months and, for some reason, won’t go away. With the tremendous issuance of new debt, repo is the mechanism that helps get that debt placed.

Equally troubling is the fact that when interest rates are low, earnings yields are low, dividend yields are low, good grief, where did the yield go? This situation begs for added leverage and guess what? What better way to turn 2% yields into 10% yields than a little (or a lot of) leverage? Again, repo is at work here.

So my great narrative may be to think back to 2007 and remember how everyone said you should continue to invest in real estate because home prices only go up. Until they didn’t. Today everyone says interest rates are low, we should borrow more, and the rates will remain low…until they are not. If this is the case, then you will see it in the repo discussion and short-term rates will reflect it.

In the meantime there are municipals. According to the same SIFMA site referenced above, municipal securities outstanding in 2006 was $3.3 trillion rising a much slower pace to $3.8 in 2019Q2. Municipal bonds are evidently pikers in the credit expansion race. The best part however is that unlike the almost universally leveraged situation in treasuries and corporate debt, municipals actually have credits with little debt and are also deleveraging. Exciting!

Eagle Mountain Saginaw Independent School District, TX

AAA (AA- Under) Standard & Poor’s AAA (AA- Under) Fitch

Permanent School Fund Guaranteed

Due 8/15 Dated 12/1/19 Maturity 8/15/2050

$135,755,000 Sold

1 2020 5.00% 1.11%
2 2021 5.00% 1.12%
3 2022 5.00% 1.13%
4 2023 5.00% 1.15%
5 2024 5.00% 1.21%
6 2025 5.00% 1.31%
7 2026 5.00% 1.40%
8 2027 5.00% 1.45%
9 2028 5.00% 1.55%
10 2029** 5.00% 1.66%
11 2030** 5.00% 1.72%
12 2031** 5.00% 1.79%
13 2032** 5.00% 1.84%
14 2033** 5.00% 1.89%
15 2034** 4.00% 2.09%
16 2035** 4.00% 2.13%
17 2036** 3.00% 2.48%
18 2037** 3.00% 2.52%
19 2038** 3.00% 2.55%
20 2039** 3.00% 2.58%
21 2040** 4.00% 2.33%
26 2045** 3.00% 2.80%
31 2050** 4.00% 2.55%

* Yield to Worst (Call or Maturity) ** Call 8/15/2028

Source: Bloomberg

This is an example of a new issue priced the week of 12/9/19

Prices, yield and availability subject to change