Hospitals, universities and other not-for-profit issuers are enjoying exceptionally low borrowing costs and rampant demand for their debt. The only problem is it is not likely to last forever.
At the first Bond Buyer 501(c)3 Super Conference, held in New York on Monday, nonprofit administrators and their underwriters described a landscape in which investors are snapping up bonds issued by not-for-profits and banks are steadily becoming more willing to extend credit.
“On balance, it’s a very strong market, a good market,” said Edward Malmstrom, head of the health care group at Bank of America Merrill Lynch, during the State of the Market panel. “But be careful, because it can change quickly.”
Top-rated universities enjoyed market access all through the credit crisis, and are still able to float debt virtually free of covenants. Low yields in the fixed-rate bond market have enabled many issuers to transition out of variable-rate facilities, at times saving money even after paying swap termination fees. More marginal health care issuers have benefited from a capitulation, in which investors have reached down the credit spectrum to pick up extra yield.
Peter Clarke, a managing director of underwriting at JPMorgan and also chairman of the Municipal Securities Rulemaking Board, said the rally in bonds has given some issuers intermediate-term borrowing costs “that don’t even have a number left of the decimal point.”
“When all this is being done, it’s great for the issuers,” Clarke said. “They’re getting the lowest rates they’ve ever seen.”
The underpinnings of the robust market are potentially ephemeral, however.
Principally, retail demand for tax-exempt debt has set records while bond prices have risen, but it is unclear whether that demand would hold up if rates start to increase significantly.
Municipal bond mutual funds reported a record $69 billion in new money from investors in 2009, according to the Investment Company Institute, easily a record. In the first seven months of the year tax-free funds reported $22.9 billion in inflows, on pace for the second-strongest year on record.
“That can reverse on a dime,” said Robert Muller, managing director of credit analysis and investor marketing at JPMorgan.
“A lot of people who put money into mutual funds on the bond side don’t actually understand that prices can decline. When [when interest rates go up] is the point of time we’re probably going to go back to a little bit of a stop-phase. We’re going to see rates go up and we’re going to see it a little harder to sell credits.”
High-yield funds in particular have been beneficiaries of heightened flows, and are likely to suffer when rates spike, Muller said.
So when will the spike in interest rates come? If you ask Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities, the answer is: sooner than you think.
In his keynote address, LaVorgna offered the most sanguine outlook on the economy many participants have heard in a long while.
LaVorgna expects the Federal Reserve to hike its target for the federal funds rate around the middle of next year, but believes the Fed could act sooner if it sees job growth for three straight months.
While LaVorgna said the economic outlook is not great, he believes some of the fears that drove bond yields to their recent floors are misguided.
In particular, talk of a “double-dip” recession disregards history. Only three times in the past 160 years, representing more than 35 business cycles, has the economy re-contracted after accelerating off a bottom, he said. Once was because of the influenza outbreak and demilitarization following World War I, and another was orchestrated by the Fed to choke off inflation in the early 1980s.
To support the no-double-dip hypothesis, LaVorgna explained that recessions are the result of an imbalance between aggregate supply and demand. When the supply of goods and services outstrips demand, whether because of a squeeze on demand or an inflation of supply, production slows until one catches up with the other.
The current recession, for instance, stemmed from inflation in home prices, which pushed the supply of housing to levels that exceeded demand.
No such imbalance exists today to push the economy back into recession, he said, as inventories of unsold homes have never been lower.
“Once you largely correct these imbalances the likelihood that you go back into recession by definition has to be quite low,” he said.
LaVorgna allowed for a reversal in the event of some unforeseeable blow to the economy, such as a terrorist attack or an oil shock.
Unforeseeable, though, doesn’t mean ignorable.
In his own keynote address, Andy Busch, global foreign currency and public policy strategist at BMO Capital Markets, cited a pertinent quotation from Mark Twain:
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
