Investment Theory: Sample of Capital Flow Analysis

Corporate Bonds

Supply and Demand for U.S. Corporate Bonds

Foreign investors are the largest buyers of U.S. corporate bonds, using funds that flow from the trade deficit.

The principal suppliers of these bonds are issuers of asset-backed securities and finance companies that serve markets for housing and consumer credit.

Non-financial corporate businesses are also suppliers of bonds, but net new bond offerings do not rise to the level of demand for fixed-income securities that comes from foreign buyers and domestic institutions.

Limits On Supply

Unlike equity markets, bond supply is limited by opinions of rating agencies and by regulatory restrictions on the quality of bonds admissible for portfolios of insurance companies and institutional buyers.

The supply of bonds is limited by the borrowing capacity of issuers.

Stock buybacks and effects of the asset-lite movement have reduced the corporate capital base.

Consequently, due to rating constraints, the supply of bonds is limited by borrowing capacity of issuers.

Strong Long-Term Demand

Long-term demand for bonds is likely to remain strong as retiring baby boomers switch from equities to fixed income securities.

Foreign demand for U.S. bonds should hold firm as long as the dollar is the major world reserve currency and the trade deficit continues to grow.  

The aging of the world population may also be a favorable influence on long-term bond prices due to increased demand for income securities.

Trade Deficits Drive Down Rates

Although in recent years the Federal Reserve Board has driven down short-term interest rates in an effort to stimulate the economy, yields on corporate bonds have been falling since 1980.

In part, this has been due to reduced expectations of inflation. However,the long-term rise in the price of bonds has been driven primarily by the trade deficit.

An excess of imports over exports has driven bond prices down.

Bonds do not provide adequate protection against inflation. The War on Terror, which may last for decades, may trigger events that shake the position of the dollar as the international reserve currency, reducing the trade deficit, putting downward pressure on bond prices.

Protectionist measures sponsored by the Democratic Party, the labor unions, and other opponents of globalization, if successful, could also drive down bond prices, increasing long-term interest rates.

A continuation of current capital flow trends would support favorable expectations regarding the demand for bonds and the level of bond prices.

What To Watch

Despite institutional limitations on supply, the virtual certainty of inflation, and a persistent increase in the trade deficit, any long-term allocation in corporate bonds should be monitored for signs of a reversal of current trends in the flow of funds accounts, especially items that deal with the trade deficit.

May 2005

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