Rate sensitivity and bond issuance

Reading time: 3 – 5 minutes

An understanding of the motivation of issuers is fundamental in Capital Flow Analysis.

The US bond market may be divided into four types of issuers, with this breakdown over the decade 1995-2004:

Interconnected markets

• F 209. Treasury Bonds (8.9% of bond issues);
• F 210. Agency Bonds (39.5% of bond issues);
• F 211. Municipal Bonds (6.9% of bond issues); and
• F 212. Corporate Bonds (44.7% of bond issues).

Each of these bond classes is governed by different parameters:

1. Primary Decision Maker: Who is it that makes the primary decision that results eventually in the issuance of these bonds?
2. Lag Between Decision and Issuance: How long is it between the time when the primary decision maker takes action that later results in these bonds being issued, and the actual issuance of the bonds?
3. Sensitivity to Interest Rates: How much is the primary decision maker influenced by current interest rates before taking the action that leads to the issuance of these bonds?

Determining the supply of US. bonds

This table shows how these parameters relate to the four main divisions of the US bond market:

Capacity to absorb increased supply

Comparing this table with the actual issues of bonds over the last decade, we can make the following observations:

1. 84.2% of the U.S. bond market (Corporates and Agencies: 1995-2004) was primarily dependent upon decisions of home owners that would change quickly based on current interest rates. This means that as the demand for bonds fell off, so would this large segment of supply. In other words, the volume of issues of the largest portion of the bond market was highly opportunistic and dependent upon the level of demand.
2. 6.9% of the US bond market (Municipals: 1995-2004) was primarily dependent upon local voters, with moderate sensitivity to current interest rates and with a medium to long term lag between the voters’ decision and bond issuance.
3. 8.9% of the US bond market (Treasuries: 1995-2004) was primarily dependent upon decisions of the US Congress that might only be reflected in issues of Treasury bonds years later, with no sensitivity to current interest rates.

The high percentage of the supply side of the bond market that is opportunistic and sensitive to interest rates, explains why long-term interest rates have been relatively stable, despite increasing demand.

This analysis also suggests that should the flow of funds from the trade deficit suddenly dry up, the first impact would be a rapid reduction in the size of the residential mortgage market, rather than a sharp increase in interest rates.

Of course, just as there have been radical changes in the agency and corporate bond market over the last decade, further changes may be expected in the future.

Past market behavior is not necessarily a predictor of the future.