Companies rush to borrow before rates fall

Borrowing conditions for American companies have improved remarkably in a few weeks. Ten-year government yields came close to five per cent not long ago. Since then benchmark rates have fallen hard and investment-grade credit spreads have narrowed towards 1.10 per cent, the tightest this year. Corporate treasurers have seized the chance and sold a wave of new bonds to lengthen their debt.

Two prices in one coupon

A company's borrowing cost has two parts: the Treasury yield for the same maturity and the spread investors demand for taking corporate credit risk. In October both worked against issuers. Since then the Treasury part has come down with the bond rally and the spread has compressed as well, so the all-in cost of a ten-year bond for a solid company has fallen by more than the move in government yields alone. Treasurers who stayed away from the market in the autumn are making up for lost time.

The two parts respond to different forces. The Treasury yield moves with expectations for Fed policy, inflation and government borrowing, over which no company has any influence. The spread moves with default risk, investors' appetite for risk and the supply of competing corporate paper. A treasurer can hedge the first with interest-rate swaps or futures, but the only way to lock in the second is to sell the bond, which is why tight spreads tend to pull issuance forward.

Refinancing ahead of 2024

Issuers have no intention of waiting for the Federal Reserve to cut overnight rates. They are selling long-dated paper now to lock in narrow spreads and get ahead of the large refinancing bill due in 2024 and 2025. Treasurers reckon that base rates may fall further but spreads have little room to tighten. Money raised for a long term today removes the danger of being unable to roll debt over later.

The bill is large because of what companies did in 2020 and 2021. They sold record amounts of debt when yields were near historic lows, and the shorter-dated part of that borrowing now has to be replaced at far higher coupons. Doing so gradually, in a receptive market, is cheaper than doing it all at once in a market that may have turned.

That earlier binge had a helping hand. In March 2020 the Fed announced, for the first time, that it would buy corporate bonds, and the promise alone was enough to reopen a market that had frozen. Companies borrowed heavily in the months that followed, often to hold cash as insurance. Many of the five-year bonds sold then fall due in 2025, and the coupons on their replacements will be roughly double.

Why spreads are so tight

Demand explains much of the squeeze. With all-in yields on high-grade bonds at levels rarely seen since the financial crisis, buyers who care about income more than spread, such as life insurers and pension funds, have been happy to take as much paper as companies offer. Insurers selling annuities need long-dated assets to match their liabilities, and pension funds whose funding has improved with higher rates want to lock in returns. That buyer base is a reason spreads can stay narrow for a while, and it is the strongest argument against rushing.

Tight spreads have a history

Narrow spreads are a poor guide to future defaults. High-grade spreads spent much of 2021 below 1 per cent, when money was free, and were similarly compressed in the calm before the 2007 credit crunch. By the worst of the 2008 crisis they had blown out to more than 6 per cent. Spreads reflect how much investors are willing to pay for yield today, and they can widen far faster than they narrowed once growth or liquidity turns.

That asymmetry is the treasurer's real argument for moving now. If the economy slows and the Fed cuts because of it, government yields would fall but spreads would probably widen, and the net saving from waiting could be small or negative. Locking in the spread today insures against that path at a modest cost.

The case for waiting

A treasurer who expects the Fed to cut sharply might prefer to borrow short now and lock in long-term money later, when base rates are lower. The weakness of that plan is that it bets on two things at once: lower Treasury yields and spreads that stay tight. Treasurers can capture much of the benefit of falling rates without the spread bet by issuing fixed-rate bonds today and swapping part of the proceeds into floating-rate payments. That is why the rush makes sense even for companies that share the market's view on rates.

Winners, losers and the queue

Investment-grade companies are the clear winners. Lower-rated borrowers, many of which depend on floating-rate loans or bonds due soon, face a harder sum, because their spreads are wider and their buyers more skittish. Their loans reset against SOFR, the overnight benchmark, which has sat around 5.3 per cent since the Fed's last rise in July, so their interest bills have already absorbed the full tightening. The other competitor for investors' money is Washington: with a deficit of about $1.7 trillion in the fiscal year to September, the Treasury has been increasing the size of its coupon auctions. Every dollar of government paper has to find a home, and when supply rises, private borrowers pay for the space.

The signals to watch are the spread itself, the volume of issuance in January, traditionally one of the busiest months of the year, and the Treasury's next quarterly refunding announcement early in the new year. A widening of spreads while government yields keep falling would show that the easy window has closed.

Companies are right to borrow now. Spreads this tight rarely last, and once the government's own long-dated issuance picks up, private borrowers will probably find the queue longer and the price higher. Expect a heavy January calendar from high-grade issuers, and expect the lower-rated end of the market, still paying floating rates above 5 per cent, to feel the strain first if growth softens in the first half of the year.