Despite declining interest rates, last year set a record for the issuance of fixed-income securities. Since January, long-term Treasuries have declined by 240 basis points (2.4 percent), intermediate Treasuries by 285 basis points and overnight money, as measured by the Federal Funds rate, was 50 basis points lower.
Several factors were responsible for these softer interest rates, which, in turn, sparked the massive outpouring of new issues. The major factor that eventually led to lower interest rates was the strong dollar in the foreign exchange market. The strong dollar had a negative impact on the goods-producing sector, especially manufacturing, mining and agriculture.
The high interest rates during the first half of 1984 came very close to nudging the economy into a recession during its second half. The Federal Reserve, realizing the inherent danger of a recession, embarked on a more accommodative monetary policy in August 1984 that continued through all of 1985. The administration and the Federal Reserve had hoped for real growth in the gross national product of 4 percent in 1985. With GNP lagging below that number, the Fed saw the necessity of continuing its accommodative monetary policy throughout 1985.
A byproduct of the high dollar and soggy economy was the welcomed progress toward disinflation. Most analysts missed the fact that inflation, as measured by the consumer price index, would fall below 3.5 percent. Consequently, as the monetary aggregate M1 grew at a double-digit rate, market participants realized that with low inflation and an anemic economy, the Federal Reserve was in no position to tighten the credit reins. This realization, plus a very positive yield curve, prompted Treasury bond buyers to lengthen maturities and purchase the much-higher yields that were available in the longer maturities. Huge sums of money were available, not only from the United States, but also from abroad. This flood of money proved an added force in moving Treasury interest rates lower.
Further proof concerning the damage the strong dollar was inflicting on the economy came in the announcement by the Group of Five industrial nations of their concentrated efforts to move the dollar lower. At the same time, expectations for reducing the federal budget deficits were raised as the Gramm-Rudman-Hollings bill became law. Concurrently, the price of oil began to fall in the spot market, another boost for disinflation. These actions had a positive influence in pushing interest rates lower. Money Markets
Short-term interest rates and money-market instruments with maturities of one year or less were greatly influenced by the slow to moderate growth of the economy, a very accommodating monetary policy orchestrated by the Federal Reserve and by the lack of demand for funds at commercial banks. In this atmosphere, interest rates were very stable and lacked the volatility of recent years. All of these factors were intertwined with one another. It was difficult not only for investors to adjust to the falling rates, but also the lack of short-term investment instruments made it difficult for money-market portfolio managers to diversify their portfolios and to keep their yields or returns at acceptable levels for investors.
Commercial banks were flush with funds, but the slow economy reduced their loan demand. Consequently, banks drastically reduced their issuance of certificates of deposit, as well as bankers acceptances (down $8 billion). Foreign economies also were slow, and this reduced the issuance of European certificates of deposit. As a result, the yield curves of these instruments flattened out, while the interest rate differentials (the spreads) between these instruments became unusually narrow.
Bucking the trend, commercial paper issuance grew by some $56 billion and partially filled the void left by the dearth of other instruments. Auto credit companies borrowed heavily through commercial paper during the fall, and nonfinancial corporations preferred to borrow at the lower rates available in the commercial paper market, as opposed to the higher rates available from commercial banks.
As short-term rates fell, investors moved from money-market funds into longer fixed-income funds, as well as into the stock market and equity funds. The assets of tax-exempt money-market funds increased by $11.4 billion while taxable money-market funds showed a slight decline. U.S. Treasury/Agency Markets
The constant need for the Treasury to roll over the ever-expanding public debt and the need to finance the federal budget deficit of $212 billion in fiscal 1985 kept the Treasury heavily involved in the marketplace. Unfortunately, the failure of Congress to extend the debt ceiling during the last quarter disrupted the Treasury's financing schedule. As of Sept. 30, the average maturity of the $1.2 trillion in marketable interest-bearing public debt held by investors was four years and 11 months. At year's end, total public debt stood at $1.95 trillion, up $288 billion over the calendar year. The interest paid on the public debt in fiscal 1985 was $179 billion.
Unofficially, the Treasury's total borrowing was $1.2 trillion. Of this amount, $181 billion represented new money raised; $8.7 billion of this money came from off-budget items and was financed for the Federal Financing Bank through Treasury offerings.
The four federally sponsored agencies -- the Federal National Mortgage Association, Federal Home Loan Bank, Federal Farm Credit Bank and the Student Loan Marketing Association -- issued $14 billion in net new money in 1985, $9 billion below 1984. The Government National Mortgage Association increased the amount of its mortgage pass-through securities by $43 billion. Municipal Markets
By any standard of measurement, 1985 was a banner year. The new-issue volume of $161.5 billion probably will not be equaled for many a year. In spite of this massive volume, the municipal market benefited from rising bond prices for the fourth year in a row.
The market was able to absorb this outpouring of new issues because the relationship of tax-exempt yields remained at record high levels. During the last few years of the 1970s, yields on prime general-obligation bonds, as a percent of yields on U.S. Treasuries, ranged between 60 percent and 70 percent. During 1985, that range was 78 percent to 87 percent. Further, the yield on a long-term A-rated revenue bond was 95 percent of the yield on a long Treasury. In effect, the high real tax-exempt interest rates proved an irresistible lure to both individual and institutional buyers.
Tax-exempt returns remained at these high levels because of the uncertainty concerning tax-reform legislation and the anticipation of future tax-rate cuts for both corporations and individuals. Uncertainty as to what types of "private purpose" issues were to be excluded from future issuance caused the deluge of new issues before the restrictive Jan. 1, 1986, deadline. With tax-exempt yields remaining at such attractive levels, commercial banks, casualty insurance companies and individuals (especially through open-ended mutual funds and unit investment trusts), sopped up the supply.
Of the total bonds issued, 70 percent were revenue issues. The largest segment of new issues was the $50 billion of refunding bonds. The decline in interest rates allowed issuers to refund outstanding issues that carried higher interest rates, with new bonds bearing significantly lower rates. Corporates and Euros
Leveraged buyouts played havoc with investors during the past year. Such strategies caused anxiety and extreme anger to owners of issues such as Beatrice and Revlon. Good corporate issues rated AA soon found their credit ratings lowered to BBB or BB because of leveraged buyouts. As a result, investors had immediate 10-point losses on securities they thought were good credit risks.
The rapid growth of illiquid assets continued in 1985. Mortgages, car loans and real-estate loans were packaged into securities and sold in the marketplace. In turn, these issues helped to swell the total volume of corporate new issues to $106 billion, a record. The strong stock market facilitated new equity issues totaling $24.8 billion, as well as $7.4 billion in convertible bonds. The largest borrowers were the finance companies of the auto firms. About 34 percent of the overall borrowing occurred in the fourth quarter, corresponding to the large decline in interest rates.
The greater "internationalization" of the capital markets in 1985 was responsible for $29 billion of U.S. corporate issues being marketed in the Euro-market. The liberalization of the foreign markets especially enabled U.S. issuers to diversify their new overseas issues in various foreign currencies. As a result, overseas Euro-deutsche mark issues, Euro-yen issues and Euro-lira issues flourished along with Euro-dollar issues. Key to making the Euro-market more successful was the further growth in the currency swap market and interest-rate swap market. The significance of the currency swap market is that a U.S. company could take advantage of lower interest rates available in Japan, sell an issue denominated in Japanese yen currency, and then swap the yen currency back into dollars, if necessary.
The floating-rate-note market continued to mature as issues the size of the $2.5 billion Government of The United Kingdom were sold. Also, older issues were called in and new issues with narrower spreads were sold.
Heretofore, Euro-equity convertibles had been sold in the Euro-market. Last year, using the old Euro-bond syndicates, large stock issues, like Nestles and Black & Decker, were sold directly into that market.
With the internationalization of both the domestic and the Euro-bond markets, both markets have become more competitive and therefore more innovative, especially the Euro-market. This bodes well not only for issuers, but for investors as well.