QE2 NO SMOOTH RIDE FOR BONDHOLDERS / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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NOVEMBER 1, 2010, 11:10 A.M. ET.

QE2 No Smooth Ride For Bondholders .


By RICHARD BARLEY

The first round of quantitative easing proved to be a bonanza for bondholders. The second round, expected to be launched by the U.S. Federal Reserve this week, is unlikely to prove such good news. It may even knock corporate bonds off the perch they've occupied for the 18 months since the Fed first bought Treasurys.


QE1 had an instant impact because credit markets were clearly dysfunctional. U.S. junk bonds were yielding more than 18 percentage points over Treasurys, and investment-grade bonds were yielding six percentage points over Treasurys, according to Bank of America Merrill Lynch data. That gave the Fed a big target to aim at.


But now markets are humming. U.S. companies like Wal-Mart and Microsoft have raised three-year funding at record low costs of under 1%. European junk-bond issuance already has hit a record €37 billion ($51.5 billion) this year with two months still to go, according to Société Générale.


So it's not clear what help more quantitative easing, which largely works by pushing up asset prices, might provide to credit markets. But it's possible to see what harm it might do. Record low yields show the balance of power has clearly shifted from investor to issuer. U.S. non-financial corporations now have $1 trillion in cash, according to Moody's, and may choose to spend it on mergers and acquisitions or share buybacks, both potentially damaging for bondholders. The risk of leveraged buyouts also is increasing, as high-yield funding costs have been reduced by low underlying rates.


Meanwhile, corporate-bond performance this year largely has been driven by the strong returns generated by underlying government bonds; if QE2 either disappoints because the scale is too small, or works too well in raising inflation expectations, Treasury yields will rise and corporate bonds will suffer too. This effect will be magnified for investors who sought yield by buying longer-maturity debt.


True, chief executives appear to remain broadly cautious and protective of credit quality. But quantitative easing ultimately is aimed at spurring animal spirits and investment. There's only so long that cash-rich companies will be able to justify caution if shareholders demand returns. Bondholders beware.


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