Cheap bonds! Sort of!

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Good morning. Calm-ish Monday. Stocks down a little, yields up a little. Deep breaths. Everything is fine. Email us: and

Big bond discounts that are no help at all

The move in interest rates since December is a really, really big deal. The yield on the 10-year Treasury has almost doubled, to 3.3 per cent, a huge change in a short time.

To see what a huge deal it is, look at what it has done to the prices of corporate bonds. Some corners of the market look downright weird now. Long duration bonds from the very strongest companies in the world are trading at huge discounts to their face values.

Take, just for example, the Apple 2.65 per cent bond, maturing in February 2051. Here’s the price:

Line chart of Price of Apple's 2051 bonds showing Dollars for 75 cents

That’s a doozy of a discount for a huge, hyper-profitable company that has $80bn in net cash on its balance sheet. The yield on the bonds has risen from 2.5 per cent to 4.5 per cent.

The discount has almost nothing to do with Apple, of course. It’s just down to the huge change in rates. The yield spread on the Apple bond over the most comparable Treasury bond has only risen about 20 basis points since the end of last year:

Line chart of Spread to benchmark on Apple's 2051 bond showing Not that different

Now, you might look at that discount and think that it would be great to own this bond if we go into a recession. Even if the recession is unbelievably awful, Apple is not going to default. Even a downgrade is very difficult to imagine. And if the recession is very bad, inflation and long rates will probably fall, and the bond’s price will rebound big time.

This is true, as far as this goes. But it doesn’t go far. As Greg Peters of PGIM pointed out to me, if you want to bet on rates, why not do so directly? You could buy, say, the Austrian 100-year bond. Look what has happened to it in the past 6 months:

Line chart of Price of Austria's 2120 bond, € showing Vienna sausage

Now that’s real rate sensitivity.

Peters allows that in a bankruptcy it is better, all else being equal, to buy a bond at a discount. You’re paying a price closer to what you will get in a recovery. But with high-quality bonds, that is not what we are worried about. Given that, Peters says, the long duration high-quality corporates don’t give you an attractive amount of return given the volatility from their rate sensitivity. He underweights them.

Bob Michele of JPMorgan Asset Management suggested to me that the discounted bonds have an advantage in a falling rate environment. Their coupons are smaller, relative to their yields, than those of non-discounted bonds. This means reinvestment risk is lower: less of the value of the discounted bond is paid out in coupons, so less of it has to be put back to work at lower interest rates.

But Peters’ point remains. If you want to play rates, there are more powerful ways than corporate bonds. The long-duration appeal of corporates is primarily for pension managers and insurance companies with long-term liabilities that need assets to match.

There is one other argument for the discounted bonds, presented recently by Oleg Melentyev, high yield strategist at Bank of America. He thinks issuers are likely to look at the discounts and buy back their own debt:

These are the highest-quality names: Apple, Google, Amazon, and Microsoft . . . Berkshire, JPMorgan, Merck . . . 

These are the companies with hundreds of billions of dollars of cash, who are staring at their bonds trading at essentially distressed levels. We think they are looking at this and discussing to what extent they should take advantage of a rare one-off windfall. We can’t imagine a scenario in which these conversations do not lead to at least some takeout activity in the secondary market.

This logic is completely insensitive to any assumptions on inflation and recession. It is highly likely to happen under most scenarios, in our view. Pension funds and insurance companies — less sensitive to mark-to-market — should be following right in their footsteps.

I’m sceptical. The reason most of these companies issue debt is not because they need the money, but rather because it is cheap, tax-deductible capital that makes their balance sheets more efficient. If they buy back the discounted debt, a gain will flow through their income statements, but the stock market won’t care, because it is not operating earnings. In many cases the companies will have to pay a tax on the gain. And if the companies want to rebalance their capital structure back towards debt, they will have to issue new debt at higher coupons. Every company is different, but for the strongest companies, I don’t see the appeal of debt buybacks.

For most people, in short, these bonds are not really on sale.

This looks glut-y

For a few weeks, we’ve been staring at survey data showing declining demand for manufactured goods. Last week, for example, the purchasing managers’ index for new orders indicated contraction. The ISM new orders index has also fallen hard in the past year, too.

But yesterday, we got some bouncier data, showing that actual orders for goods are holding up better than the surveys. New orders for durable goods (stuff consumers buy) grew 0.7 per cent in May, while non-defense capital goods orders (stuff companies buy) rose 0.5 per cent.

Big picture: investment intentions are gloomier than actual spending figures, which are also slowing, but more gently. The black line below shows spending on capital goods (chart by Michael Pearce of Capital Economics):

You could think of this as robust business activity supporting the economy despite rising rates. Or it could be another sign gluts are forming. As durable goods orders rose, inventories also grew 0.6 per cent in May, following a 0.9 per cent bounce in April. As MUFG’s George Goncalves put it:

It comes back to how much inventory do people want, or anticipate they need . . . So I’m not taking this [durable goods] number today as a great outcome, because, if anything, this makes the inventory problem worse.

Perhaps goods demand will pick up fast enough to sponge up excess inventories. The odds look long. As the goods-to-services rotation pushes on, retail sales fell in May. Credit card loan growth, which looks to have peaked, also hints at dwindling demand. You can, of course, also buy services with your credit card — but peaking loan growth during a rotation toward services hardly suggests roaring goods demand:

Line chart of Credit card loans by commercial banks, % change from prior year showing Turnaround incoming?

The data have surprised us before. We’ll be watching the personal consumption expenditure data for May, which drops on Thursday, with rapt attention. (Ethan Wu)

One good read

This paper says that big, heavily-traded stocks follow trends, while smaller, less-traded stocks tend to experience short-term reversals. Hat tip to Verdad Capital for pointing it out. Here is Verdad’s earlier paper on the topic, arguing that: “Value is mean reverting. Growth trends.”

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