BOND SURGE DRIVEN BY LACK OF SUPPLY / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

ABREAST OF THE MARKET

SEPTEMBER 20, 2010.

Bond surge driven by lack of supply

With U.S. borrowing still down, buyers seeking safety of debt compete for what's available; some bubble behavior.

By MARK GONGLOFF

Lost in the debate over whether the bond market has entered bubble territory is the simple concept of supply and demand.

At the same time investors are snapping up bonds for their generally safe returns, borrowing overall is down as the U.S. economy continues to recover from its debt-fueled binge.

Despite nearly two years of heavy borrowing by the federal government and nonfinancial corporations, the total amount of debt outstanding in the U.S. is still nearly $700 billion lower than it was at its peak in the first quarter of 2009, according to Federal Reserve data released Friday.

The result is that investors competing for the limited supply of debt are driving bond yields down.

"It's more accurate to say that we're still disgorging the last credit bubble than that we're starting a new one," says Harvard economics professor Kenneth Rogoff, who has studied financial crises with Carmen Reinhart of the University of Maryland and notes that new credit bubbles don't typically form immediately in the aftermath of old ones.

Despite nearly two years of heavy borrowing by the federal government and nonfinancial corporations, the total amount of debt outstanding in the U.S. is still nearly $700 billion lower than it was at its peak in the first quarter of 2009, according to Federal Reserve data released Friday.

While most analysts don't think the bond market is in a bubble, they are seeing a repeat of some of the behavior from the last run-up. "In 2001-2003, clients were desperate for yield and were willing to invest in stuff you could tell was risky because it promised a higher return," says George Feiger, CEO of Contango Capital Advisors. "You see the same pressure today."

That explains why companies have been able to issue $172 billion in new high-yield debt so far this year, already an annual record, according to data provider Dealogic. Junk-bond prices returned to par last week for the first time since 2007, after falling to less than 55 cents on the dollar at the height of the credit crisis, according to Martin Fridson, global credit strategist at BNP Paribas.

Yields on these bonds have tumbled from a 2008 high of nearly 20 percentage points over Treasurys to a spread of just 6.2 percentage points, according to Barclays Capital indexes. At the height of the previous credit frenzy, however, such spreads fell to just above two percentage points, and junk spreads are still nearly a full percentage point above their lows for the year, set in late April.

That suggests to bond bulls that the junk-bond rally could run further. Bond bears argue that junk bonds could suffer no matter what the economy does. If it weakens, defaults could increase. And if the economy strengthens, interest rates could rise and because spreads are so tight, junk bonds could see losses.

Investment-grade bonds are priced more richly. Yields are 1.8 percentage points above Treasurys, according to Barclays indexes, one percentage point wider than at the height of the previous credit bubble.

The flows into bonds show no signs of abating. Investors have poured more than $600 billion into bond mutual funds since the beginning of 2009, according to the Investment Company Institute. During that time, investors have pulled more than $32 billion out of stock funds.

Bond-fund inflows in March hit their highest level as a percentage of disposable income on record, based on data going back to 1984, according to analysis by Howard Simons, bond strategist at Bianco Research in Chicago.

So far, however, a little more than half of that money has gone into relatively safe Treasury debt and mortgage securities issued by government-backed agencies such as Fannie Mae and Freddie Mac, according to Fed data through the second quarter.

A little less than half of the fund flows have gone into corporate bonds, according to the Fed data. And less than $29 billion has flowed into high-yield bond funds since the end of 2008, according to combined data from the ICI and Standard & Poor's Leveraged Commentary & Data Group.

Though he believes the day of real credit froth is still a long way away—possibly not until 2013—Mr. Simons says the risk persists for as long as short-term rates remain near zero and the Fed drives longer-term rates lower by buying Treasury bonds.

"What we're doing now is squeezing yields on everything from the short end to the longer end down to zero, like squeezing toothpaste out of a tube," says Mr. Simons. "As we try to get the last bit out, we put the tube in a vise. People are going to be leaving bonds and heading into things that are increasingly esoteric."

Another more subtle point argues against a bond bubble: the greed factor. Investors bought dot-com stocks to get rich, but no one expects to get rich from bonds.

About 38% of U.S. household disposable income is in bonds and other debt instruments, according to Fed data, still below the levels of the mid-1990s, before the tech-stock bubble sucked more of their cash into equities.

"There's no question there's a huge premium on fixed-income products, but to call it a bubble is ridiculous," says David Rosenberg, chief economist and strategist at Gluskin Sheff in Toronto. "It's more than just price, it's also about psychology. Are people really buying bonds to get rich?"

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