During Q3 2005, U.S. households were sellers of corporate bonds on an unprecedented scale, probably in anticipation of a projected crash in the bond market as a result of much-publicized Federal Reserve interest rate hikes.

(See: Federal Reserve Flow of Funds Table 212: Corporate and Foreign Bonds.)

Over the decade 1995-2004, U.S. households bought corporate bonds at an average annual rate of $12.3 billion. In contrast, in Q3 2005, the annual rate of household bond sales rose to an astounding $350.8 billion!

We note that the Federal Reserve publishes flow of funds data as annual rates. In the case of yearly data, the annual rates are equal to the actual flow of funds. However, in the case of quarterly data, the number needs to be divided by four to arrive, approximately, at actual flows over the quarter. This convention makes it easier to compare quarterly data with annual data when attempting to evaluate the relative impact of flows. In Q3 2005, households did not actually sell $350.8 billion in bonds, but rather only about $89.2 billion. Nevertheless, this was a significant amount. In fact, level tables for households show that their holdings of corporate bonds fell from $213.3 billion in Q2 2005 to $124.1 billion in Q3 2005 — a sell-off of 40% of their bond portfolios!

Why Bond Prices Didn’t Plunge

With such heavy selling on the part of households, one would expect bond prices to plunge and yields to soar. However, Moody’s AAA rates (seasoned bonds) rose only from 5.06% in July 2005 to 5.13% in September 2005.

The reason that bond prices didn’t plunge in Q3 2005 was that foreign investors were buying corporate bonds at an equally impressive rate. The graph, which shows the major bond buyers over the last decade, indicates that purchases by foreign investors essentially neutralized the downward pressure exerted on bond prices by domestic households.

The graph highlights the buying pressure exerted by the four big perennial buyers of bonds in the U.S. market: foreign investors, life insurance companies, mutual funds, and property and casualty insurance companies.

In this case, we can identify different motivation between two sectors — a basic principle of Capital Flow Analysis. In Q3 2005, U.S. households were motivated to sell bonds out of fear of a collapse in bond prices triggered by Federal Reserve actions. Foreign investors, on the other hand, were primarily seeking a safe long-term means for holding dollars.

(See: “Foreign Investors Buy U.S. Bonds At Record Levels“)

This entry was posted on Sunday, January 29th, 2006 at 5:18 pm and is filed under Corporate Bonds, Individual Investors. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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