Bonds: What's Behind the Bounce in Corporates?

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Cisco Shows the Way

"Cisco [Systems] (CSCO) was the first one to put some size in there, and now everybody is following suit," says Bill Larkin, portfolio manager of fixed income at Cabot Money Management in Salem, Mass. What helped Cisco sell $4.0 billion of five- and 10-year notes on Feb. 9 for relatively small premiums over Treasuries was the fact that it's one of very few technology companies the market expects to weather the recession and continue to generate strong cash flow, he says.

Cisco had to agree to pay buyers of $2 billion in 10-year notes a coupon of 4.95%, roughly 200 basis points above the 10-year Treasury bond. That's quite reasonable, compared with the 550-basis point premium to Treasuries the company would have had to pay two months earlier to attract buyers, says Larkin.

As much as corporate debt spreads have narrowed in the past two months, they are still wide by historically standards, having been less than 100 basis points before the credit crunch began in 2007. Once the economy stabilizes and conditions start to improve, there will be lots of room for further tightening of spreads, says Murphy at RiverSource.

Special Programs Breed Confidence

It's prudent for underwriters to offer new issues at a nice discount relative to the prices at which existing bonds are trading in the secondary market in order to ensure sufficient participation so the deal will be oversubscribed, says Manny Labrinos, a corporate bond portfolio manager at Nuveen Asset Management in Chicago. "It's similar to the IPO market where you want to price it so it trades up rather than down" once it hits the secondary market, he says.

Total returns on investment-grade corporate bonds between Dec. 1 and Feb. 17 are 8.9%, as measured by Barclays U.S. Investment Grade Corporate Bond Index.

However encouraging the rally in corporate bonds since early December, the positive returns are being generated less by the fundamentals of an improving economic outlook than by confidence engendered by special programs guaranteeing certain kinds of debt introduced first by the Federal Reserve and more recently by the U.S. Treasury Dept., according to Mike Brandes, senior fixed-income strategist at Smith Barney, a division of Citigroup (C). "There's an extraordinary appetite for investment-grade paper, partly triggered" by the Fed's promise to purchase $100 billion of government agency debt and $500 billion of agency mortgage-backed securities and the FDIC's Temporary Liquidity Guarantee Program (TLGP), he says.

Large Deals Boost Liquidity

Indeed, the TLGP contributed 14 bond offerings worth $39.7 billion, or over 31% of the 94 deals worth a total of $127.1 billion with maturity greater than 18 months done this year through Feb. 17 by investment-grade U.S. companies, according to Dealogic, a research firm in New York.

One benefit the larger-size debt issues has had is to boost liquidity of those bonds when they start to trade in the secondary market, which can bolster confidence in the corporate bond market.

Labrinos at Nuveen sees liquidity in high-quality investment-grade bonds improving and is now a much smaller concern among bond investors than it was a few months ago. The larger size of bond offerings has made the major Wall Street firms more willing to make a market in certain issues that they don't own but that clients are requesting since they're confident they'll be able to easily buy back bonds to cover short positions if needed without having to pay a premium.

The key question investors should be asking is whether a bond has already priced in ratings downgrades that are likely to happen, says Labrinos. "If you're holding a single-A bond already trading at spreads reflective of triple B bonds and you think it's going to get downgraded to triple B and stay there," you'll be willing to buy it at the current price, he says. It all comes down to what rating you think the bond will ultimately settle at once this tough credit cycle ends.

Top-Quality Companies Benefit

For his part, RiverSource's Murphy is relying less on the rating agencies and more on his own models to determine companies' credit quality.

Ultimately, the current thaw in the corporate market remains limited to the companies on the upper rungs of the ratings ladder. The fact that more than $100 billion of investment-grade bonds have been issued so far this year demonstrates that access to the capital markets for high-quality non-cyclical companies is improving, but that doesn't mean that low-triple B cyclical companies will be able to get a bond offering done in the next three to six months, says Murphy. "The market's not there yet," he says. For now, bond investors appear content to nibble at the offerings of higher-quality names.

Bogoslaw is a reporter for BusinessWeek's Investing channel.