As interest rates have declined over the past seven years, the volume of new issue financing in all financial markets has risen dramatically. This is true even in the stock market which has been propelled upwards as interest rates have plummeted. And the municipal market set records in 1985 with a total outpouring of $205 billion of new securities.
As it looks now, 1986 is going to be the year of the corporate bond. In 1985, corporate bond issuance totaled a record $75.6 billion. Unofficially, through the first six months of 1986, $80.5 billion of new corporates have been marketed.
With the new issue calendar averaging $3.8 billion of corporates each week, the marketplace literally has been deluged.
In order to market these new bonds, a new issue is priced at a yield spread off of a Treasury issue with a similar maturity. For example, in early January, a 30-year AA public utility bond was priced to offer 120 basis points more yield than the 30-year Treasury.
As the new issue primary market continued to grow, the secondary market languished. What developed was a two-tier corporate bond market as buyers of the new issues sold their old bonds into the secondary market to pay for the new bonds. Consequently, the dealers have been unable to move the older bonds and they are loaded with inventory while the yields on these seasoned bonds have continued to rise. Concurrently the new issues were being priced off a declining Treasury yield with the resulting two-tier market which in many instances had led to higher yields being available in the secondary market than available in the primary market.
But as the secondary market has offered higher returns than the primary market, the yield spreads between the new issues and the Treasuries also have increased. A new 30-year AA public utility is being priced to return 190 basis points more yield than the 30-year Treasury. As long as interest rates stay constant or move lower, and as long as the corporate calendar continues to flourish, this two-tier corporate bond market will exist. Further, if it looks as if a much lower corporate tax rate will emerge from the present tax reform effort, many corporations may attempt to do their financing before the lower rate becomes effective, adding to the new issue volume.
Lebherz has 27 years of experience in fixed-income investments.