A Red Flag for Bonds

09/14/2010 1:00 pm EST

Focus: BONDS

David Fried

Editor, The Buyback Letter

David Fried, editor of David Fried’s Buyback Letter, says recent rock-bottom interest rates on corporate bonds may signal the end of the bond market’s amazing rally.

US corporations are issuing bonds left and right, led by International Business Machines (NYSE: IBM), the world's biggest computer-services company. A week ago, IBM raised $1.5 billion at the lowest interest rate on record: 1%, on three-year notes. That's just 0.3 percentage point more than the yield on government debt of similar maturity.

The notes have the lowest coupon of the more than 3,400 securities in the Barclays Capital US Corporate index of investment-grade company debt.

The surge in US corporate bond issuance set a record last month, as yields on the debt fell to the lowest in more than four years. IBM was joined by New York-based Citigroup (NYSE: C) and ArcelorMittal (NYSE: MT), the world's largest steelmaker, among at least five other issuers marketing debt at the same time.

Just days ago, DirecTV (Nasdaq: DTV), the largest US satellite-television provider, sold $3 billion of debt in a three-part offering to capitalize on record low borrowing costs to refinance bank loans and buy back shares.

It's a window of opportunity for companies, as the money is inexpensive and investors seeking yield over Treasuries are plentiful. Strong companies are able to leverage their good balance sheets to take advantage of this situation.

But IBM historically [seems to be able] to sell bonds at low rates just before rates climb. IBM's acumen in issuing debt foreshadowed interest rate hikes in 1979, 1989, 1993, 1995, 1996, 2002, and November 2009.

The company's impressive record is why analysts and seasoned investors pay attention, and believe that this may signal a market high for bonds.

If history repeats, rates will again climb, pressuring bond prices. Remember, IBM is issuing debt today because they think they would have to pay a higher interest rate tomorrow. The bond buyers are buying because they either think that rates will be lower later or they have to park the cash somewhere and have no better alternative.

If IBM is a great indicator of when interest rates are at a low, and interest rates are going to start to increase, it means a couple of things.

1. Refinance the house or car now if you are thinking of it and have not yet done so. In fact, any borrowing that you are contemplating should be done sooner rather than later as rates are likely to go up.

2. If the dividend income from [your long-term bond] holdings keeps you happy, you are fine. However, if you may need the principal, then it might be a good time to sell debt, just like IBM is doing.

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