Debt strategists at top-ranked Wall Street firms can’t agree on what investors should do as yields on everything from government to corporate and asset-backed bonds plunge to record lows.
While JPMorgan Chase & Co. (JPM:US) forecasts a “year-end storm in the market for U.S. Treasuries,” Barclays Plc (BARC) advises buying government bonds and cutting investment-grade company debt. Bank of America Corp. (BAC:US) recommends high-grade bonds over both junk- rated and U.S. government notes. The three firms are rated the best at fixed-income research by Institutional Investor magazine.
The stakes are mounting, with the four-year-old rally in U.S. corporates leaving little room for further gains, as the Federal Reserve suppresses benchmark borrowing costs to ignite an economy still recovering from the worst financial crisis since the Great Depression. Investors who shifted toward riskier assets in response to the central-bank stimulus are reassessing their holdings as credit quality shows signs of deteriorating.
“Right now we have a delicate situation,” Hans Mikkelsen, a credit strategist at Bank of America in New York, said in a telephone interview on Oct. 4. Longer term, “Treasuries are the riskiest fixed-income asset class,” he said.
Investors have funneled $61.3 billion into bond funds globally through the third quarter, on pace to surpass the record in 2010, according to data compiled by EPFR Global of Cambridge, Massachusetts.
Yields on investment-grade bonds in the U.S. fell to an unprecedented 2.83 percent on Oct. 3 from the 2012 high of 3.93 percent on Jan. 4 and a record 9.3 percent reached four years ago during the financial crisis, according to Bank of America Merrill Lynch index data.
Gains in the safest parts of the corporate bond market “appear to have largely played out,” the Barclays strategists wrote in the Sept. 25 global outlook. For investors looking for ways to mitigate risk, “safe-haven assets and U.S. Treasuries, in particular, serve that purpose much more effectively than high-grade corporate credit,” they said.
Elsewhere in credit markets, Nestle SA increased the size of its first sale of dollar bonds in four months as European companies tap U.S. debt markets at the fastest pace in a year- and-a-half. Deere & Co.’s finance arm plans to sell bonds in a two-part benchmark offering that includes its third sale of floating-rate notes this year.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell the most in more than three weeks, declining 1.75 basis points to 12.5 basis points. The gauge, which is approaching the more than two-year low of 12.31 reached on Sept. 14, narrows when investors favor assets such as company debentures 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 on corporate debt or to speculate on creditworthiness, rose 1.5 basis points to 96.6 basis points as of 11:11 a.m. in New York, the highest since Oct. 2, according to prices compiled by Bloomberg.
In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings increased 1.7 to 130.9.
The indexes typically rise as investor confidence deteriorates and fall as it improves. 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.
Bonds of state oil company Petroleos de Venezuela SA, known as PDVSA, are the most actively traded dollar-denominated corporate securities by dealers today, with 104 trades of $1 million or more as of 11:12 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
PDVSA’s $6.15 billion of 8.5 percent notes due November 2017 were little changed at 88.2 cents on the dollar after falling 2.3 cents yesterday following President Hugo Chavez’s re-election by 9 percentage points on Oct. 7 in a vote that polls had shown was too close to call.
Nestle, the world’s largest food company, joins borrowers from Barclays Plc to French oil company Total SA that raised a total $49 billion from dollar bonds in September, the biggest monthly sales tally since March 2011, according to data compiled by Bloomberg. European issuers have sold $15 billion of so- called Yankee bonds this month.
Nestle’s senior unsecured bonds due January 2018, which were increased to $500 million from an initial plan of $300 million, will yield 43 basis points more than the benchmark swap rate, down from about 50 basis points offered in initial marketing, according to people with knowledge of the Vevey, Switzerland-based company’s deal who asked not to be named before the sale is completed.
John Deere Capital Corp. (DE:US) intends to issue two-year debt with floating coupons as well as fixed-rate bonds maturing in 2020, according to a person familiar with that offering who asked not to be identified because terms aren’t set. The sale will be of benchmark size, typically at least $500 million.
The tractor-maker’s finance unit sold equal $500 million portions of senior unsecured floating notes yielding 15 basis points more than the three-month London interbank offered rate in June and 17 basis points more in February, according to data compiled by Bloomberg.
Investors deposited $1.2 billion into U.S. investment-grade bond funds last week, building on the previous week’s $2.3 billion, according to JPMorgan research. They yanked $892 million from speculative-grade bond funds after pouring record volumes into the debt earlier in the year on signals that slowdowns in business investment and exports were restraining economic expansion.
Speculative-grade, or junk, bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
Yields on investment-grade bonds have fallen to about half the average of 5.1 percent from the past decade, Bank of America Merrill Lynch index data show. Speculative-grade bonds in the U.S. have returned 12.5 percent this year, with yields dropping to an unprecedented 6.948 on Sept. 19.
The “stretched valuations” are justified given central banks’ policies, Barclays analysts led by Larry Kantor in New York wrote in their global outlook, titled “Don’t fight the Fed.”
The central bank “continues to elbow investors out of safe assets and into riskier asset classes,” the analysts said. Investors should consider the “intense desire” of policy makers in the U.S. and Europe to “protect and strengthen their respective economies.”
U.S. government bonds gained 0.4 percent in the three weeks after Sept. 13, when the Fed said it would conduct open-ended purchases of mortgage debt as it continues a program to reinvest in the market. Yields on U.S. Treasuries are at about 1.7 percent, below the 2 percent inflation rate predicted by analysts surveyed by Bloomberg.
The European Central Bank is joining the Fed in suppressing borrowing costs through debt purchases, with ECB President Mario Draghi announcing an agreement on Sept. 6 for an unlimited bond- buying program to tamp down interest rates and fight speculation of a currency breakup.
While there will likely be strong demand for fixed-income assets in the near term, JPMorgan expects yields on 10-year Treasuries to rise to 2 percent at the end of 2012, according to strategists led by Terry Belton in a report Sept. 28, when they were yielding about 1.63 percent.
An investor buying $10 million in face value of Treasuries at the current yield of 1.74 percent would lose $182,000 if the yield should rise to 2 percent at year end, Bloomberg data show.
“We’re really viewing this as the calm before a year-end storm in the Treasury market,” Belton, JPMorgan’s global head of fixed-income and foreign exchange research, said in a video message e-mailed to clients on Oct. 1. Belton’s team was top- ranked for fixed-income strategy in Institutional Investor’s poll this year, beating strategists from Barclays and Bank of America.
Barclays recommends investors buy government bonds, including U.S. Treasuries, as a haven while also purchasing the riskiest tiers of both investment-grade and high-yield debt to increase returns, according to the report.
Barclays’s view on high-grade credit contrasts with that of Bank of America, Morgan Stanley (MS:US) and Goldman Sachs Group Inc., which like the notes for debt buyers. Goldman Sachs strategists said that the $6.5 trillion market for investment-grade company bonds is the most attractive for risk-averse fixed-income investors in a Sept. 28 report.
The best way for debt investors to insulate themselves against rising interest rates is with credit spread, Charles Himmelberg, managing director and Goldman Sachs’s global head of credit strategy, said in a telephone interview.
“If I can go anywhere, I like high yield,” he said. “We’ve liked high-quality high yield for the past year.”
Debt strategists at Morgan Stanley and Bank of America prefer investment-grade bonds to junk notes in the U.S.
Goldman Sachs doesn’t recommend buying the lowest rung of high-yield bonds while Barclays strategists advise investors to purchase them selectively.
Investors have been buying riskier and riskier corporate bonds as government-debt yields drop, causing the lowest tier of speculative-grade notes to gain 2.7 percent since the end of August, Bank of America Merrill Lynch index data show. U.S. government bonds have declined 0.5 percent this month while junk notes gained 0.5 percent after an Oct. 5 report showing the U.S. unemployment rate unexpectedly fell to 7.8 percent last month, the lowest since President Barack Obama took office in January 2009.
While high-yield bonds still offer investors 5.55 percentage points more than government debt, firms including Morgan Stanley and Bank of America have become tepid on the securities as the credit quality of speculative-grade borrowers deteriorates.
The ratio of upgrades to downgrades by S&P for speculative- grade companies has plummeted to 0.31 in the three months ended Sept. 30, the least in more than three years, from a peak of 2.22 in the three months ended in June 2010.
Leverage is increasing by the most since 2009 as issuers capitalize on record-low borrowing costs. Speculative-grade companies had debt in the second quarter that on average was 3.26 times earnings before interest, taxes, depreciation and amortization, “creeping higher” from 3.12 times in the same period of 2011, Morgan Stanley strategists Adam Richmond and Jason Ng wrote in a Sept. 14 report.
“I think returns in high yield will exceed returns in high grade going forward, but not enough to make up for the higher risk in the high-yield asset class,” said Bank of America’s Mikkelsen.
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