It’s no secret that central bank asset purchases and investors’ desperate hunt for yield have driven yields to record lows on everything from government bonds, to SSAs, to IG, to HY. This has regrettably had the effect of ensuring that spreads signal virtually nothing to investors about the riskiness of any particular issue as the market has become so distorted that it can no longer facilitate price discovery. This is great if you’re a company looking to leverage [6] your balance sheet because it means you can borrow for next to nothing, and the beauty of the whole thing is that what looks like next to nothing to you looks great to investors who have seen yields on their risk free assets fall to zero or below, so finding buyers for new issues is easy (unless you’re a Australian iron ore producer [7] that is). Corporates can then funnel the proceeds from new bond offerings back into their own stocks via buy backs, driving prices higher and artificially boosting the bottom line. Here’s what this looks like:
[8]
As it turns out, there may be yet another circular dynamic at play which serves to push the bubble machine even further into hyperdrive. As JPM notes, soaring equity prices have had the effect of altering investors’ asset allocations, effectively tipping the balance towards equities even as money flows into bond funds:
Retail investors remain strong buyers of bond funds. YTD retail investors poured more money into bond than equity funds, with the former attracting $73bn YTD vs. $47bn for equity funds. This pattern of higher bond vs. equity fund buying has been repeated in every year since 2009 with the exception of 2013’s Great Rotation…
We note that the speculative motive has been important for most of the past seven years as the almost steady decline in bond yields have provided strong capital gains to investors…
But we note there is another reason that has motivated retail investors to buy bond funds, which is the large capital appreciation of equities in recent years. Equity prices have risen by 50% in the US and by 30% globally over the past three years and this has made retail investors more overweight equities vs. bonds even as they bought more bond than equity funds over the same period…
This is reflected in the US Flow of Funds data released last week for Q4. The equity weighting for US households stood at 35% at the end of the year, six percentage points above its level of three years ago and above its previous 2007 peak. In other words US households appear to be very overweight equities by historical standards and have thus an incentive to buy even more bonds funds to prevent their equity overweight from becoming more extreme. Similarly, US pension funds and insurance companies appear to be overweight equities and underweight bonds as can be seen in (ZH: note that we have discussed this on a number of occasions, see here [9] and here [10]). This increases their incentive to buy even more bonds to prevent their bond weighting from falling too much as equity prices rise…
Household, pension, and insurance fund allocations:
[11]
The bigger picture for pension funds:
[12]
And at the 30,000 foot level, the picture remains the same:
Most of the rise in equity allocations is due to price appreciation. With new equity issuance very limited compared to outstandings, the world as a whole can only raise its equity holdings by pushing up its price. The equity weighting of the global investor stands decisively above the bond weighting, a sharp contrast to the 2008-2012 period when the bond weighting was above that of equities for most of the time. By now, the shares of bonds and cash are below their 25-year averages while the share of equities is 2% above its historical average...
[13]
The result is ever more demand for bond funds, driving borrowing costs still lower and stamping out the last vestiges of the market’s price discovery mechanism:
The more equity prices increase, driven by either hedge funds or investors with low equity allocations, such as Japanese pension funds or economic agents with high cash allocations such as corporates and EM households, the higher the incentive by other investors, such as US pension funds and US households, who are already very overweight equities to buy bonds to prevent their bond allocation from falling too low or their equity allocation from rising too high vs. historical averages. In other words, higher equity prices can increase bond demand by investors who are already very overweight equities, thus boosting bond prices and depressing bond yields further.
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Summing up, central banks first drove interest rates to the zero bound which encouraged corporates to borrow and drove investors into riskier assets. The lower yields went, the more desperate investors became, and the more debt companies issued. Rather than spend the proceeds on capex, companies funnelled the money back into their own stocks, driving up equity prices, which distorted the asset allocations of the very investors who just bought their bonds, which means that ironically, re-leveraging companies utilizing financial engineering to boost their share prices have actually managed to kill two birds with one stone by not only inflating the value of their equity, but by simultaneously ensuring they’ll be still more demand for their debt. Meanwhile, the central banks of the world are now buying ETFs [14] and will soon be buying [15] individual stocks, which will serve to further drive up equity prices creating demand for corporate debt only to have the companies buy back stock, and around we go.
The bubble machine is thus complete.
