Sales of junk bonds in the U.S. have already set a record for August, even as yields at about record lows combined with a slowdown in earnings growth spark concern the market for the riskiest corporate debt has peaked.
Charter Communications Inc. (CHTR:US), the cable-TV provider that emerged from bankruptcy in 2009, and Energy Future Holdings Corp., the Texas power producer struggling with $36.6 billion of long-term debt, are among companies that have sold $29.6 billion of speculative-grade securities this month. That compares with an average $8.4 billion in August sales for the past five years, according to data compiled by Bloomberg.
Companies are tapping into an unprecedented $44.9 billion of cash that has poured into funds that buy junk bonds in 2012 as the fourth year of near-zero short-term interest rates prompts investors to put their money into higher-yielding assets. Issuance accelerated even as the pace of earnings at speculative-grade companies slowed in the second quarter and as U.S. unemployment held above 8 percent for the 42nd month.
“It has become such a feeding frenzy,” Bonnie Baha, who helps oversee $40 billion as head of global developed credit at DoubleLine Capital LP in Los Angeles, said in a telephone interview. “It’s almost like credit fundamentals don’t even matter in markets like this. You’ve got too many dollars chasing too few bonds.”
The average yield on speculative-grade debt was 7.4 percent yesterday, 0.2 percentage point from the record low 7.19 percent reached in May 2011, Bank of America Merrill Lynch index data show. The extra yield investors demand to own the bonds instead of Treasuries has dropped 135 basis points, or 1.35 percentage points, since June 5 to 588 basis points.
Concerns the slowing economy will suppress company earnings and trigger an increase in defaults “have been steamrolled by the renewed push to reach for yield,” Oleg Melentyev, a New York-based credit strategist at Bank of America Corp., said in an Aug. 14 report. Flows into credit funds “in some respect are reaching bubble levels, never before breached in history.”
Elsewhere in credit markets, the cost to protect against corporate defaults in the U.S. reached a 10-week low. The extra yield investors demand to hold the top-ranked portion of bonds backed by commercial mortgages dropped to the lowest since at least January 2008.
Bonds of New York-based Morgan Stanley were the most actively traded dollar-denominated corporate securities by dealers today, with 45 trades of $1 million or more as of 11:55 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.5 basis point to 21 basis points. The measure, which has declined from a four-month high of 39.13 on May 15, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, fell 1.2 basis points to a mid-price of 102 basis points, the lowest since May 8, according to prices compiled by Bloomberg.
In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings declined 0.8 to 145.5.
The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit swaps 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 contract protecting $10 million of debt.
In commercial mortgage-backed securities market, spreads on the Barclays CMBS AAA Super Duper Index narrowed 5 basis points yesterday to 147 basis points. The relative yields have dropped from 261 basis points at the end of 2011, the index data show.
Junk-bond offerings in August, typically constrained by U.S. summer holidays, surpassed the previous record of $23.7 billion for the month in 2010, Bloomberg data show. Sales are higher than the monthly average of $16.1 billion the past five years and less than the $44.7 billion sold in May 2011, the most in any month. Companies have sold $197 billion of the debt this year.
Speculative-grade, or junk, bonds are rated below Baa3 by Moody’s and lower than BBB- by Standard & Poor’s.
U.S. investment-grade bond sales in August of $42.7 billion are below the record $92.7 billion for the month in 2007, Bloomberg data show.
“The market’s strong and bankers are certainly pushing companies to come to the market opportunistically now and not wait until the September-October time frame,” said Thomas O’Reilly, who co-manages the $3 billion Neuberger Berman High Income Bond Fund (NHINX:US) in Chicago.
Charter Communications sold $1.25 billion of 5.25 percent, 10-year debt last week to yield 373 basis points more than similar-maturity Treasuries, Bloomberg data show. The funds will help redeem bonds with a 13.5 percent coupon maturing November 2016. The St. Louis-based company exited Chapter 11 bankruptcy in November 2009 with its debt reduced by about 40 percent, or about $8 billion.
Energy Future, taken private in 2007 in the largest buyout in history, sold $850 million of securities in a two-part offering, including a $600 million add-on to its 11.75 percent second-lien notes, to repay a loan to one of its units, Bloomberg data show. The company’s capital structure is complex and “untenable,” according to Moody’s Investors Service, which downgraded the company’s debt to Caa3, nine levels below investment grade, the day the bonds sold on Aug. 9.
The $44.9 billion deposited into high-yield funds globally through Aug. 8, as measured by Cambridge, Massachusetts-based EPFR Global, compares with $14.3 billion in the same period last year.
Investors are being lured by returns more than seven times what would be earned holding Treasuries and government agency debt, Bank of America Merrill Lynch index data show. Speculative-grade bonds in the U.S. gained 9.65 percent this year through Aug. 14, compared with 1.32 percent for government debt, Bank of America Merrill Lynch data show.
While total yields have declined, spreads over government debt have widened from last year’s low of 452 basis points on Feb. 21 and are more than pre-credit crisis levels of 291 basis points at the start of 2007, Bank of America Merrill Lynch index data show.
At the same time, the trailing 12-month default rate of 2.8 percent in July among global speculative-grade companies has held below the historical average of 4.8 percent in Moody’s data going back to 1983. Moody’s projects the rate will increase to 3.1 percent by year-end.
“There’s a certain resilience in the high-yield market,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in a telephone interview. “It’s still our No. 1 asset class pick for the balance of 2012.”
The rally may be pressured as the economy slows, Bank of America’s Melentyev said.
Speculative-grade companies reported growth in earnings before interest, taxes, depreciation and amortization, or Ebitda, of 1.2 percent in the second quarter, down from high single-digit growth in the past few quarters, the analyst said in the research note this week.
“You take a step back and ask the question, ‘Let’s look at valuations; what’s happened with the balance sheets behind this market?’ and it just doesn’t add up,” Melentyev said. “High- yield is an economically sensitive market, as opposed to investment-grade which is much less so, and is very sensitive to risk appetite.”
The International Monetary Fund on July 16 cut its global growth forecast for 2013 to 3.9 percent from a 4.1 percent estimate in April. The European Commission forecasts a 0.3 percent contraction for the 17-nation euro economy this year. The Italian economy contracted 0.7 percent in the second quarter, extending a recession that started last year, while Spanish GDP fell 0.4 percent.
The U.S. unemployment rate was 8.3 percent in July, up from 8.2 percent the previous month, according to the Labor Department in Washington.
“There’s this cavalier attitude that nothing bad is going to happen and all of these credits are going to do fine,” Baha said. “The magnitude of the bust is usually equal to or greater than the magnitude of the boom. I can’t help but think that there’s going to be a day of reckoning.”
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