September 23, 2010

Fixed Income Focus: A U-Turn in Treasuries, and Implications of Microsoft’s New Issue

The first half of September was a striking reversal from the anxious market activity in August. Virtually overnight, Treasuries became an afterthought as investors stampeded back into the stock market amidst positive economic news (triggered initially by the ISM manufacturing report and the August employment report).

The equity rally has driven up each major index (S&P, DJIA, & NASDAQ) between 3% and 6% so far this month, which has (at least temporarily) taken the momentum out of a Treasury market that has been rallying steadily for about six months. For one of the few times since yields peaked in early April, 10-year Treasury prices fell and yields increased for two consecutive weeks (from 2.58% to 2.75%). The ripple effect impacted mortgage rates, which also crept up a bit.

But the increase in yields didn't pass through to the retail corporate bond market because credit spreads tightened during that same period. This makes sense, since spreads are a proxy for risk. When investors are less fearful spreads tend to decrease.

Trading activity in the fixed income market was mostly stable during the first half of the month. On the retail side, trade counts for individual bonds were consistent with August. Likewise, inflows into fixed income mutual funds were largely unchanged in September (and still near historical highs). The most noteworthy changes were net fund flows out of equities. During the last week of August nearly $10 billion was redeemed from equity funds, according to Investment Company Institute (ICI) data, but during the first week of September that figure fell to just over $1 billion as many investors tried to capture the upside of the rally.

One of the more interesting developments in September was Microsoft's announcement that it will issue debt to fund a stock repurchase and to pay dividends. This has been a common practice among public firms throughout 2010, since yields for corporate bonds are at all-time lows and share prices have also been trading below their historical valuations. The move will immediately benefit Microsoft because they can take shares out of circulation, thus driving up their earnings per share and their share price. Beyond the one-time benefit, the strategy implies that MSFT expects its future equity returns to exceed the cost of borrowing, which is a positive indicator for the economy and more bad news for Treasury investors. On the other hand, using borrowed funds to buy shares rather than to expand business operations suggests that growth opportunities are limited.

In either case, the timing of the announcement could be taken as evidence that interest rates are near a bottom. Microsoft can tap the fixed income markets at any time to raise money, but presumably management has chosen right now because Microsoft wants to lock in the lowest possible rates. Only time will tell if the software giant has guessed correctly....

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