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Are Corporate Bonds Another Bubble in the Making?

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The answer is no -- at least, not yet.

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The bond bonanza continued on Monday as another $8.75 billion of new corporate bonds were sold. The total could have been higher had a couple of deals not been pushed out to the next few days. The mood was even better in the derivatives space, with credit default swaps (CDSs) of large US financials down sharply, and the broad Markit HY CDX Index also tighter by a strong 13bps.

With the corporate bond market in overdrive, over the weekend I received an important and recurring question: Are corporates another bubble in the making?

In my humble opinion, the answer is no -- at least, not yet. I've long embraced the view that a key element needed for a bubble is the "democratization" of an asset class. In the late 1990s we had a stock bubble because anyone with a 56k modem could buy and sell Internet stocks, and sure enough, just about everyone did. From 2003-2007 we had a housing bubble because anyone could borrow "money for nothing" to buy one or more homes, only to sell them months later to some other sucker. Once again, virtually anyone with a pulse did just that. Through the centuries, from tulips to railroads, the "bubble" movie has pretty much been the same.

Now ask yourself this: Have many of you recently chatted with friends and neighbors about flipping the Sprint (NYSE:S) 6% of 2022, or the Apple (NASDAQ:AAPL) 2.4% of 2023, which you could have bought yesterday for $88.85? My guess is no. Away from mutual funds, which don't really get traded, the corporate bond market remains the domain of very large institutions – pension funds, insurance companies, etc. – whose concern is not to flip the bonds but rather to build a portfolio that will generate the return bogie needed to cover their liabilities.

For reasons that would take up a whole separate article, right now these big buyers are flush with cash, and their main problem is that they can't find enough bonds at the yield required to generate the income they need. And not only are they flush with cash, but more and more of it keeps coming in. The biweekly Pensions & Investments newspaper offers a section that highlights new allocations of money to various funds. Just in the latest edition it listed more than $2 billion of fresh cash earmarked mostly for credit, real estate, and private equity funds.

Before you mumble "$2 billion? Big deal!" consider that the managers of the credit/ real estate/ and PE funds are not "cash buyers." Because of their investors' high return bogies (7.5%, 8%, some even 8.5%), and the fact that market rates are closer to 3% than 4% (thank you Ben Bernanke), the managers lever up their bond investments multiple times (emphasis on multiple). So it is entirely reasonable to expect that in the current environment, the $2 billion of fresh cash will generate $15-30 billion of buying power. And before this cycle is over, don't be surprised if that leverage gets to the 25x-35x range. I won't even discuss the role of the "Alphabet Soup Monsters," which are coming back with a vengeance. Note also that the $2 billion is just a sampling of what gets allocated on a biweekly basis, with total estimates ranging anywhere between $20-40 billion per month.

If in the above dynamic you think you have spotted a "bubble," i.e. the leverage, this time you are probably correct. There will come a point when the flows of new cash will dry up and the leverage will get pushed to extremes; and once the first margin calls kick in, the snowball effect will be as devastating, or worse, as what we saw in '08-'09. But based on the current lay of the bond land, that point looks to be a long way away – as in several years. And hopefully, as we get close to the end game, our "tells" will give us at least a bit of fair warning.

Twitter: @FZucchi
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Position in AAPL.
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