Bloomberg News

Spreads Diverge From Ratings by Most in 20 Years: Credit Markets

September 06, 2011

Sept. 6 (Bloomberg) -- Fear is overpowering greed in the $7.6 trillion U.S. corporate bond market, with investors pricing in the biggest reversal in credit quality in more than two decades as the economy falters and Europe’s debt crisis worsens.

While Moody’s Investors Service raised the ratings on 12 investment-grade companies in August and lowered seven, relative yields on corporate debt jumped more than half a percentage point, the third-largest increase since at least 1989, Deutsche Bank AG strategists say. At no point in at least 22 years has the difference between bond spreads and the ratio of upgrades to downgrades been greater, according to Deutsche Bank.

The divergence between ratings and yield spreads underscores the division between investors over whether the slump will prove fleeting or mark the end of a rally that produced returns of 46 percent on average since 2008. The bulls bet that companies, which have $1.91 trillion in cash and other liquid assets on their balance sheets, can withstand U.S. unemployment at 9 percent and growing headwinds from Europe.

“There are some real tail risks to the global economy here, in the order of what we saw in ‘08,” said Ashish Shah, head of global credit investments at AllianceBernstein LP in New York, which oversees $210 billion in fixed-income assets. “Unlike ‘08, when people were very slow to price in those tails, we’re now at a stage where people have priced them in much more rapidly than we saw in the past.”

Luring Investors

The surge in yields is luring investors including Pacific Investment Management Co., manager of the world’s largest bond fund, which views debentures issued by banks as among the best investments. Guggenheim Partners LLC is “aggressively” buying high-yield bonds and views the widening in spreads as unwarranted.

“The balance sheets of corporate America are as strong as they’ve been in over 30 years,” said Santa Monica, California- based Scott Minerd, the chief investment officer at Guggenheim, which oversees more than $100 billion. “It would seem very unlikely that even if we did have a recession, we would see a material increase in defaults.”

Elsewhere in credit markets, Lockheed Martin Corp. plans to sell notes as investment-grade debt issuance shows signs of reviving. Huntington National Bank is leading $2.55 billion of bond offerings backed by auto loans and the cost to protect U.S. and European company debentures jumped.

Bethesda, Maryland-based Lockheed Martin’s sale, which may be used to repay debt and for general corporate purposes, may include five-, 10- and 30-year bonds, according to a person familiar with the transaction, who declined to be identified because terms aren’t set. The debt may be sold in benchmark size, typically at least $500 million.

Bond Sales

Enbridge Energy Partners LP may also issue $750 million of debt maturing in 10 and 29 years, and Detroit Edison Co. is marketing $140 million of bonds due in 2041, according to people with knowledge of the transactions.

Bond sales for investment-grade companies in the U.S. may reach $80 billion this month, according to Bank of America Corp. strategists, after plunging to $50.5 billion in August, the least since May 2010. Issuance fell 30 percent to $3.98 billion last week, according to data compiled by Bloomberg.

Huntington National’s $1 billion offering of bonds backed by auto loans will be the Columbus, Ohio-based lender’s fist sale of asset-backed securities since March 2009, when the bank sold $963 million in bonds through a Federal Reserve program to jumpstart lending, Bloomberg data show.

AmeriCredit Financial Services, the auto lender purchased by General Motors Co. last year, that makes loans to buyers with blemished credit, is marketing $800 million of bonds tied to car loans, a person familiar with that sale said. Banco Santander SA is marketing $750 million of bonds backed by auto loans.

Credit Gauges

The Markit CDX North America Investment Grade Index, a credit-default swap benchmark that rises as investor confidence in creditworthiness deteriorates, rose 8.4 basis points from Sept. 2 to a mid-price of 129.4 basis points as of 11:59 a.m. in New York, according to Markit Group Ltd. The index is trading at the highest since June 2010. U.S. markets were closed yesterday for the Labor Day public holiday.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings jumped 5.1 basis points to 185.3 basis points as of 4:38 p.m. in London, Markit prices show. The index is trading at the highest since March 2009.

The Markit iTraxx SovX Western Europe Index of credit- default swaps on 15 governments climbed 3 basis points to 329 basis points.

The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.

Relative Yields

The extra yield investors demand to own U.S. investment- grade corporate bonds instead of Treasuries climbed to as high as 227 basis points on Aug. 26, the most since October 2009, before falling back to 221 to end the month, according to Bank of America Merrill Lynch’s U.S. Corporate Master index. Spreads widened from 166 on July 31.

Relative yields on debt rated below investment-grade soared 172 basis points last month to 730 and reached a 23-month high of 750 on Aug. 26, based on the Bank of America Merrill Lynch’s U.S. High Yield Master II Index.

Spreads expanded even as cash held by investment-grade borrowers stood at the highest in a decade last quarter and corporate debt burdens fell to 1.92 times earnings before interest, taxes, depreciation and amortization costs, from a peak of 2.2 times in the third quarter of 2009, according to JPMorgan Chase & Co. strategists.

‘More Liquidity’

“They have more liquidity, lower debt ratios and have prefunded more maturing debt than has occurred in any time than before 1980,” said Guggenheim’s Minerd, who isn’t anticipating the U.S. will dip back into recession.

With balance sheets bolstered and companies refinancing debt at some of the lowest absolute borrowing costs on record, Moody’s has raised its long-term ratings this year on 1.14 companies for each one it lowered, according to data compiled by Bloomberg. At the height of the financial crisis in the first quarter of 2009, downgrades outnumbered upgrades by more than 10 to 1.

“At no point in more than 20 years has the difference between credit spreads and the downgrade to upgrade ratio been larger,” Richard Salditt, a credit strategist in Deutsche Bank’s credit sales and trading group, wrote in a Sept. 1 report. “Simply put, current credit spreads are already compensating investors for a significant deterioration in credit quality.”

No Deterioration

The surge in risk premiums is unjustified and investors should increase their holdings of corporate credit, Morgan Stanley credit strategists wrote in a report distributed today. “Although a U.S. recession or Eurozone sovereign shocks are risks, we think risk premiums are too elevated and unlike ‘normal’ cycles we have not seen a deterioration in balance sheet quality,” the analysts wrote.

While relative yields on investment-grade debt have jumped, overall yields have barely moved over the past month because of a rally in Treasuries as money managers sought the safety of U.S. government debt. Yields climbed as high as 3.83 percent on Aug. 24 before falling back to 3.62 percent on Sept. 2, the same as they were at the end of July, Bank of America Merrill Lynch index data show. That’s down from more than 9 percent in October 2008.

“The problem with the current level of yields on investment-grade corporate debt is given the rally we’ve had in Treasuries, despite the spread widening, the absolute rates are still relatively unattractive compared to other asset classes,” Minerd said.

Spreads Volatile

Europe’s still-unresolved sovereign debt crisis and concern that the economy is slowing is likely to keep spreads volatile, according to AllianceBernstein’s Shah and strategists at JPMorgan, who in a report last week maintained a target of 250 basis points for relative yields on investment-grade companies and said investors should hold less of the debt than their benchmarks.

The median estimate of more than 50 economists surveyed by Bloomberg News is for U.S. gross domestic product to expand 1.7 percent this year. That’s down from 2.5 percent in a June poll.

“Most investment-grade corporate bonds and even the highest quality high-yield bonds have the balance sheets to handle ‘stall speed’ and even a mild recession,” Mark Kiesel, the global head of corporate bond portfolios at Pacific Investment Management, or Pimco, said last week in an e-mail response to questions.

In Europe, the European Central Bank began buying Spanish and Italian government debt last month to curb a surge in bond yields as contagion from the debt crisis that engulfed Greece, Ireland and Portugal begins to infect the region’s third- and fourth-largest countries.

“We’re going to remain quite volatile, because we have a lot of uncertainty,” Shah said. “There are opportunities in both investment-grade and high-yield, but you have to be underwriting to a higher standard.”

--With assistance from Tim Catts, Zeke Faux and Sarah Mulholland in New York. Editors: Pierre Paulden, Michael Shanahan

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Sapna Maheshwari in New York at sapnam@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net;


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