MARKET COMMENT
Beware Of A Bond Glut

By David Kuo (TMFDragon)
November 5, 2001

Carburton Street, London -- Boots (LSE: BOOT) brought the issue of risk-averse investments to the fore last week when it revealed that its pension fund had moved entirely out of shares and into bonds. This is because bonds are perceived as a lower risk investment, although bondholders of Railtrack (LSE: RTK) may disagree. The bonds that Boots opted for are triple A-rated corporate bonds and gilts, normally regarded as the safest, though jaw-achingly boring, forms of investment.

But as investors' appetite for bonds start to grow, it is likely that more companies will move into the market and issue bonds in preference to new shares. Companies need working capital to finance continuing growth of their businesses and if bonds happen to be the flavour of the month then so be it. From the company's perspective, they will raise capital in the most economical way possible. With interest rates at their current low levels bonds are much more cost effective.

Take for example a recent report that Merck (NYSE: MRK), the world's third biggest pharmaceutical company plans to raise over $1.5b in the form of bonds. The drugmaker said it plans to use the proceeds for general corporate purposes including debt reduction and possibly investments. Merck is essentially swapping its more expensive older loans for cheaper ones. It will also use the money for financing investments that will produce a better rate of return than the interest it will have to pay on its new loan notes. In other words it is working towards increasing shareholder value.      

But as demand for bonds starts to accelerate, more companies will offer corporate debt in preference to shares. And as any economics student knows, as the supply of any commodity increases, the price must necessarily fall and this will mean lower returns for bond investors.