There is something fishy going on in U.S. credit markets and it may give stocks at least a temporary boost.
August, typically a sleepy month for corporate bond issuance heading toward the Labor Day holiday weekend, has seen record issuance in its first six days, according to New Albion Partners LLC.
The flurry is messing with the yield spreads that help bond investors contemplate risk. And for stock investors, this phenomenon means that the debt-fueled share buyback craze may be revived.
Companies sold $70 billion of bonds in the six-day stretch, already more than half the normal monthly average issuance of $125 billion. Why sell? Companies are aware of hungry buyers, among cash-flush public pensions in particular, so they’re more than happy to come to market now. Pension funds are itching for yield in a low-return world and are now allocating much of their cash stash to company bonds, even if typically higher risk than government bonds.
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“There has never been an August like this in the history of finance, and it isn’t close,” said Brian Reynolds, chief market strategist at New Albion.
At this pace, the corporate credit market would only need $5 billion a day in issuance for the next 11 days to set the market up for a record year. That, too, is surprising, given the credit market was essentially locked down for more than a quarter of the year so far, swept up in market panics in January, February and most recently in June following the U.K. “Brexit” vote to leave the European Union.
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The really strange thing is that this new wave of issuance has coincided with a sharp tightening of credit spreads, lowering the “payout” an investor receives for accepting the perceived long-term risk of a company’s inability to make interest payments or repay its bonds. Those spreads hit yearly lows in spring and are now poised to push even lower, say analysts.
“All else being equal, an increase in the supply of new corporate bonds tends to push spreads wider, as was the case with last year’s record-setting flows,” said Reynolds. “The combination of near-record credit flows and significant spread compression means that this year is unlike anything ever seen in the history of finance.”
As the following chart illustrates, investment-grade derivative spreads have not taken out their post-Brexit lows. It suggests that bearish macro funds — the biggest players in the credit derivative market — are still downbeat on credit and are holding on to their positions. That collides with August’s record credit flows and narrowing spreads and makes it likely that the post-Labor Day issuance surge will intensify the credit boom.
“The persistence of bearish credit derivative positions indicates to us that, should those credit flows trigger forced margin calls, there is the potential for record credit flows extending into next year,” said Reynolds. “Those flows will end up on corporate balance sheets, giving CEOs even more fuel to power their stock prices higher through financial engineering.”
Companies can give their stock a temporary boost by moves like buying back their stock, but long term, those efforts can hurt stock prices as they use up money that could be invested for growth. Borrowing to buy back shares is risky, as it adds leverage to a company’s balance sheet.
S&P 500 companies spent $163 billion on buybacks in the first quarter—the second-largest quarterly expenditure in history, according to a recent note by Goldman Sachs. The pace slowed in the second quarter, however, as companies found they were being penalized by investors.
By the end of July, S&P 500 companies had authorized $276 billion in buybacks year to date, down 31% compared with the same time in 2015, said Goldman. The bank found that investors were rewarding companies that pay dividends over those that conduct big buybacks.
A basket containing stocks with the highest trailing four-quarter buyback yields underperformed the S&P 500 by 280 basis points, or 2.8 percentage points, in the year to date, Goldman found.
Read: Share buyback machine remains in overdrive and experts warn it will end badly