How the Bond Market Became the Dow's Best Friend

Gains in the Dow Jones Industrials have come in large part from a solid bond market. Find out why.

May 20, 2014 at 12:30PM
Longview

The Dow Jones Industrials (DJINDICES:^DJI) had fallen back 95 points as of 12:30 p.m. EDT Tuesday on a combination of subpar earnings reports from the retail sector and general concerns about a potential market correction. But even with the pullback, the Dow remains close to its record-high level, in large part due to the bond market's strength. By allowing Microsoft (NASDAQ:MSFT), Cisco Systems (NASDAQ:CSCO), and hundreds of other companies both within and beyond the Dow Jones Industrials to take on more debt, the bond market has helped increase leverage and improve stock returns -- at least during good times.

Traditionally, companies used to take on debt only when necessary. For Dow members, that usually meant occasional massive takeover bids for large peers, such as seen lately as both Dow telecoms spent tens of billions to buy lucrative assets. For them, a healthy bond market fortuitously reduced interest expenses.

More recently, though, low interest rates have spurred moves to lever capital structures more extensively. The popularity of stock buybacks has soared as many dividend-paying companies have been able to make cash flow positive moves by issuing low-interest bonds and using the proceeds to repurchase high-yielding shares. Not only do those moves help improve cash flow, they also magnify the upward moves in share prices as profits are spread across a smaller number of shares.

Msft

Issuing bonds has had an added incentive for Cisco Systems, Microsoft, and other tech stocks. Cisco and Microsoft, along with many of their peers, have extensive amounts of cash on their balance sheets. Yet much of that cash is held within offshore business entities, and bringing back that cash for use in stock-buyback operations would subject it to repatriation taxes. In response, Microsoft and Cisco Systems have issued bonds to raise additional cash to repay shares, while using offshore cash balances in part to shore up their bond ratings and give lenders added confidence that their bonds will be safe.

Csco

Will the good times last?
The key question is why investors would buy bonds from Dow tech components such as Microsoft and Cisco Systems at such low rates. For institutions, having dependable, highly rated corporate bonds is useful as a diversifier beyond Treasuries and other high-quality government bonds. For ordinary investors, earning additional yield beyond what banks will pay has some value, despite the risk that any tech company faces in surviving changing industry conditions throughout the bond's lifetime, which can span for decades.

Yet as long as some investors are willing to buy up corporate debt at rock-bottom yields, Cisco Systems, Microsoft, and other opportunistic companies should keep benefiting from the bond market. Only once yields start to rise for good will the companies in the Dow Jones Industrials have to figure out other ways to keep their profits high.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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