Financial sector deleveraging to drag on total bond growth
- Financial bonds will experience 14 quarters of deleveraging; will return to growth in 2012
- Nonfinancial bond growth will slow relative to Fed action-inspired increases of 2009
- Overall, total bonds outstanding is holding up far better than during the Great Depression
Placing today’s corporate bond growth in context
During the Great Depression, the outstanding level of nominal corporate bonds collapsed by 12.7% from 1932 to 1938 despite deflationary pressures. Major triggers of this collapse were the Federal Reserve’s inaction and a massive contraction in industrial production alongside widespread bankruptcies; with such a reduction in economic activity, the need for bonds dwindled. Fast forwarding to today’s economic context, the Fed’s zero interest rate policy and liquidity support ensured that the contraction in corporate bonds outstanding was short-lived. Large companies rely on the bond market. Long-term bond financing also facilitates plant and equipment investment. By pulling on the lever of long-term interest rates, the Fed could jolt balance sheet repair in the corporate sector and push long-term investment. This was a major failing of policy action during the Great Depression. Although the decision to move forward with long-term investments is beset by unusually-high uncertainty, the corporate sector did considerably refinance its long-term debt.
As such, nonfinancial corporate bonds continue to grow, which keeps total credit growth in the US from falling off a cliff. With recovering industrial production and stabilizing corporate spreads, nonfinancial bond growth will remain positive. However, given expectations of higher yields in the future, nonfinancial bond growth will slow. With the Fed expecting to keep rates low for an extremely long period of time, this issue is not necessarily an immediate concern, but it does drive the long-term forecast. Cheap financing terms cannot last forever. In the early 1980s, the Volcker Fed’s assault on inflation through serious negative real interest rates brought real outstanding nonfinancial credit growth to a standstill. Nonfinancial bonds are just one of three major components of total outstanding corporate bond growth.
In contrast to nonfinancial bond growth, for financial bonds outstanding we expect 14 quarters of deleveraging in real terms, lasting until 2012. Peak-to-trough, we anticipate 18.1% deleveraging in financial bonds outstanding, comprising roughly $1tr in real financial bonds. Financial bond issuance – outside of challenging economic conditions and the aftermath of a financial crisis – also faces nontrivial regulation restrictions. Foreign corporate bond growth, representing the third plank of total bonds outstanding, will proceed alongside a recovery in world trade, although it will remain variable due to the dollar exchange rate and the international appetite for raising funds in dollars given relative interest rates.
US Corporate AAA Industrial Yield Curve
The outlook for the US corporate yield curve depends on Fed action, expectations of the strength of the economic recovery, and the outlook for inflation. The Fed’s current program of Large Scale Asset Purchases (LSAPs) should incrementally increase inflation expectations. However, our baseline is for a first increase in the Fed funds rate in 2012. The Fed would also be concerned about excessive credit growth, but in the case of bonds, growth rates will not upset the Fed.
Corporate Spreads Over 10 Year Treasury
Corporate spreads in 2010 are higher than in late 2009. Recent months’ increase in corporate spreads represents some combination of Fed LSAPs and uncertainty over European sovereign debt. At the same time, in the US total bankruptcies are subsiding and the Commercial and Industrial (C&I) charge-off rate is in decline. If investors become wary of holding Treasury notes and bonds and the economy recovers, corporate spreads could tighten. In the very long term the typical BAA spread is around 200bp.
Weekly High Yield and Investment Grade Bond Volume
Recent weeks have witnessed holiday season bond volumes. Over the past twelve months, volume has trended downwards, with specific weakness during the summer. This is likely related to high macroeconomic uncertainty that rippled through the economy as a result of disappointing housing indicators. Securities lending, however, has trended upwards in the form of total securities credit reported by the Federal Reserve Flow of Funds Z.1 Release.
Corporate Bonds Outstanding Forecasts
We expect an average total bonds YoY growth rate of 2.6% in 2011 and 4.7% in 2012. Financial bonds will represent the primary drag on total bonds outstanding. The average real YoY growth rate of total bonds outstanding is 6.4% from 1953Q1 to 2010Q3, so our forecasts are consistent with below-trend growth rates. Total bond growth does not necessarily grow all the time in real terms. For example, total bonds outstanding hovered around $10.4tr for all of 2009. During the Volcker Fed, high bond rates brought the market to a standstill. As interest rates change in the coming years, this is something to monitor closely.
