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  • Mispricing Risk on Bonds

    Posted by Carl from Chicago on October 21st, 2010 (All posts by )

    Interest rates are at an all-time low.  Companies are able to borrow money and pay almost no interest under the most favorable of terms.  This one caught my eye:

    SAN JOSE, Calif.–(BUSINESS WIRE)–eBay Inc. (NASDAQ:EBAY) today announced the pricing of a $1.5 billion underwritten public offering of its senior Notes, consisting of $400 million of 0.875% Notes due 2013 (the “2013 Notes”), $600 million of 1.625% Notes due 2015 (the “2015 Notes”) and $500 million of 3.250% Notes due 2020 (the “2020 Notes”). The public offering price of the 2013 Notes was 99.793% of the principal amount, the public offering price of the 2015 Notes was 99.630% of the principal amount, and the public offering price of the 2020 Notes was 99.420% of the principal amount, in each case plus accrued interest, if any. The offering is expected to close on October 28, 2010.  eBay intends to use the net proceeds from the offering for general corporate purposes, which may include working capital, acquisitions and capital expenditures.

    It is completely astounding that a company with a business model like eBay is able to borrow for:
    – 2-3 years at under 1%
    – 5 years at under 2%
    – 20 years at a bit over 3%

    These are not secured debt items; they are notes – and per the description above, eBay can use the money for anything they want, including working capital, which means that they can use the money for ANYTHING.  THIS IS LESS THAN 1% ABOVE THE RISK FREE RATE (i.e. what you can get for Treasuries).  This is absolutely unprecedented.

    This article in today’s Wall Street Journal essentially tells the same story with Wal-Mart.  Wal-Mart was also recently able to sell debt at an absurdly low premium over the risk free rate.  Per the article:

    Wal-Mart sold $750 million worth of three-year bonds paying 0.75% a year. It sold $1.25 billion of five-year bonds paying 1.5%, $1.75 billion of 10-year bonds paying 3.25% and $1.25 billion of 30-year bonds paying 5%.

    The difference between Wal-Mart and eBay is that WMT also has an instrument that delivers yield as well as some potential for appreciation; a stock paying a dividend.  The dividend on the shares of WMT yield a bit over 2% a year and receive preferential tax treatment (due to the dividends received deduction) to boot.  Per the article:

    Wal-Mart has raised dividends by an average of 16% a year over the past decade. If it merely raises them by 10% a year in the future, the yield on the stock will surpass that on the 10-year bonds within about five years. It will surpass that on the 30-year bonds within 10 years.

    I have no idea why someone would buy debt, which has many risks (the risk of inflation in the economy, as well as a company specific risk) with this sort of minuscule premium, especially when taxation is so unfavorable (it is taxed as ordinary income today and highly likely tomorrow).

    This is the equivalent of a “bubble market” for bonds.

    Cross posted at LITGM and Trust Funds for Kids

     

    10 Responses to “Mispricing Risk on Bonds”

    1. Robert Schwartz Says:

      You a correct it is a bubble. And, there will be hell to pay when it pops. But, when and how is that going to happen.

    2. phwest Says:

      You buy the bonds because bonds get paid before dividends. If you are bearish on the economic picture going forward and see deflation rather than inflation as the likely money trends, then bonds are the way to go.

      Personally, I’d just as soon have cash as lend money at those rates, but not everyone can afford to forgo the current income.

    3. David Foster Says:

      There are some cases where it might be rational to buy such bonds. If you have cash, and also have specific obligations that will require that cash in, say, 3 years…then if you buy the WMT stock, it may be trading significantly lower at that point in time, even absent catastrophic scenarios. But if you buy the WMT 3-year bond, you know you’ll get the face value when it matures.

      I suspect that most of the purchases of these bonds are not of this type, though; they’re people and entities that got burned by too much reliance on equities and are now swinging the other way.

      There are a lot of people with significant assets who don’t want to talk or even think about stocks at this point..not a rational attitude, but a common one.

    4. Anonymous Says:

      This is what you get with the fed pumping liquidity into the system as hard as they can. QE I and QE II are making debt absurdly cheap.

    5. David Foster Says:

      Meanwhile, loans for small and mid-market companies tend to be pretty expensive (when they’re available at all)…10%-12% does not seem to be uncommon for a 3-5 year *secured* (first-lien) loan.

    6. Michael Kennedy Says:

      There are a lot of people with significant assets who don’t want to talk or even think about stocks at this point..not a rational attitude, but a common one.

      The investment letter I have read since 1977 has suggested that all the subscribers get completely out of the stock market but he is recommending gold. I wish I had taken his advice back in 1999 when it was about $250 an ounce. I did take his advice in 1978 and doubled my money in 6 months.

    7. shannon Love Says:

      Major bubbles like the real estate bubble tend to produce subsidiary bubbles when they pop just like soap bubbles floating on top of water do. Money fleeing the main bubble pours into other areas regardless of that areas actual potential because the money has no where else to go. The fed pumping money into the system doesn’t help either.

      In the end, the market is a type of cybernetic i.e. non-digital, computational system that operates on interlinked feedback loops. Driving one loop to the extreme with cause distortions in the other loops. It will take years, up to a decade or more, for all this to settle down.

    8. Roy Says:

      Question I continue pondering: why do peaople save at all when forgoing present consumption gains negative reward vs inflation? And faces suffocating probability of significant, expensive social turmoil in next decade(s)? Put diffently: how can people sell the incredibly low returning ‘investments’ Carl lists? Put still another way: Can anyone explain to me how come the returns have not increased to get people to part with their money?

    9. Michael Kennedy Says:

      Roy, I have noticed a related phenomenon. In the late 70s, when inflation took off, there was a great burgeoning of precious asset shops. In Laguna Beach, two friends of mine, gay physicians well known in Laguna, opened a crystal shop. They made a fortune to the point that they were the largest seller of Lalique crystal in the world. They traveled to France and were given the key to the city where Lalique is made. There were also many antique shops that sold mid-level antiques. There was a great rush to get rid of dollars and buy assets that would hold their value. There was no housing bubble although housing prices in Orange County doubled. That is when I doubled my investment in gold. Fortunately, I sold at the peak as it fell again over the next 20 years.

      I see nothing like that now. Housing is in deflation still. Gold is still in a great bull market but there is no equivalent bull market in assets like crystal or antiques. Some of this may be because those assets did not hold their value once inflation was conquered by Volker and Reagan. Still gold is climbing after a similar collapse in the 80s and 90s.

      Maybe it is the anticipation of collapse of the currency. It is interesting that Democrats simply can’t see this. I think it is extremely dangerous that the two major political parties have markedly opposite world views. I can’t think of a similar situation in American history.

    10. sol vason Says:

      1% interest when inflation is 0% is the same as 20% interest when inflation is 19%. 1-2% is the normal interest rate for US treasuries after adjustment for inflation.

      Most gold exchanges do not have enough gold on hand to make delivery on all the gold they have sold. If you buy gold, take delivery. Then get it assayed by an honest person – and assay all the gold, not just a sample. When you sell it, you will probably have to allow another assay. In evil times, watch the assay to make sure nothing is stolen.

      A better investment is guns and ammunition.