With interest rates at rock-bottom levels, investing in bonds seems like a recipe for disaster. Yet if you think only the dumb money is buying bonds, take a closer look. You'll find that many companies are making offers to buy back outstanding bonds.
You buy some, you sell some
You have to look really closely to find out about bond buybacks, though. What most bond investors are focusing on is the huge amount of newly issued bonds from blue-chip corporate issuers.
Over the past several months, highly rated companies have one-upped each other by issuing debt at successively lower interest rates. IBM
But some corporate issuers are going the other way, choosing instead to repurchase outstanding debt. One way issuers can accomplish this is through a bond tender offer, where the company typically pays a premium to bondholders in exchange for their permission to retire the bonds early. Given that low interest rates and the popularity of corporate bonds generally have already pushed bond prices to high levels, adding a premium on top of that can get very pricey for companies.
Whether that makes sense depends on the reasoning behind the buybacks. In some cases, it's a justifiable move to take advantage of a unique opportunity.
It's all in the timing
The dilemma that many companies find themselves in is that although interest rates are low right now, there's no guarantee that they're going to stay this low for long. And unless a company happens to have its bonds maturing in the next month or two, it has to be concerned that rates will rise before it has a chance to refinance its debt.
Just as most homeowners have to wait for their old home to sell before they can buy a new one, so too do companies typically have to get rid of their existing debt before they can take on a new debt issue. Even those companies that can find bond buyers without extinguishing their current bonds risk a rating downgrade.
So if a company is buying back bonds only so it can then turn around and issue new bonds at much lower interest rates, then that makes plenty of sense. That's what Rio Tinto
On the other hand, if a company is simply retiring debt, then it could hardly pick a worse time to do so. Delta Air Lines
Of course, paying down debt is always a healthy sign for a company, especially in an industry that's been challenged by balance sheet problems. But doing so when prevailing interest rates are low is the worst time possible, because that's when the amount a company has to pay in order to entice bondholders to give up their bonds is as high as it's going to get.
All of this assumes that the bond market rally is on its last legs. If rates somehow keep falling from here, then those who buy back their bonds now may look like geniuses, while the companies who issued early will look like they passed up even better bargains later. For the moment, though, it's clear that the majority of companies see the current bond environment as an opportunity to extend their debt financing that they can't afford to pass up.
Forget about bonds. Legendary value investor Bill Miller thinks these stocks will rise 50%.
Fool contributor Dan Caplinger is no buyer of bonds right now. He doesn't own shares of the companies mentioned in this article. Microsoft and Wal-Mart are Motley Fool Inside Value picks. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended diagonal call positions on Johnson & Johnson and Microsoft. The Fool owns shares of IBM, Johnson & Johnson, Microsoft, and Wal-Mart . 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 Fool's disclosure policy tells you what we're buying.