Bloomberg News

House of Morgan Divided on Junk as Returns Wane

December 04, 2013

JPMorgan Chase & Co. recommends sticking with U.S. high-yield bonds next year as the best protection against rising interest rates. Morgan Stanley cautions that valuations are unattractive following a record five-year rally.

Speculative-grade debt will return 5 percent in 2014 with default rates remaining below historic averages, according to analysts at JPMorgan, the largest underwriter of the notes since 2010. Investors need to lower their expectations and will see gains of 2.8 percent, Morgan Stanley said yesterday.

Wall Street is diverging on how much life is left for bonds that soared 119 percent in the four years from the depths of the credit crisis through last December. This year’s 5.7 percent gain on a Bloomberg high-yield index has been tempered by mounting concern over how quickly the Federal Reserve will curtail unprecedented stimulus that’s bolstered credit markets.

“High yield simply fares better” in a rising interest-rate environment, said Peter Acciavatti, whose team at New York-based JPMorgan is top-ranked for speculative-grade strategy by Institutional Investor magazine. “It’s a better place for investors to invest in.”

March Paring

Yields on the Bloomberg USD High Yield Corporate Bond Index soared to a one-year high of 7.02 percent in June from a record low 4.66 percent in May as investors anticipated the central bank was poised to cut the pace of its bond buying if the economy showed sustained improvement. The index lost 3.1 percent in June, the most since August 2011.

After Fed Chairman Ben S. Bernanke surprised markets in September by maintaining the pace of $85 billion of monthly purchases of mortgage bonds and Treasuries, yields on the Bloomberg index (BUHY) fell to 5.88 percent as of Dec. 2. Economists predict policy makers will pare the monthly pace of bond buying to $70 billion at their March 18-19 meeting, according to the median of 32 estimates in a Bloomberg News survey on Nov. 8.

Average prices for junk debt of 103.4 cents on the dollar compare with an average since 2003 on the Bank of America Merrill Lynch U.S. High Yield Index of 96.2 cents. Speculative-grade debt is ranked below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.

‘Robust’ Market

“We aren’t arguing investors avoid high yield,” Adam Richmond, Morgan Stanley’s head of U.S. leveraged finance strategy, said in a telephone interview from New York. “We’re arguing that absolute returns are going to be low by historical standards.”

With the Fed stoking an appetite for riskier assets by holding its benchmark interest rate at between zero and 0.25 percent since December 2008, high-yield debt returned an average annualized 21.6 from the end of that year through 2012, Bank of America Merrill Lynch index data show.

Corporate treasurers will find a “robust” market for new issuance even as sales are expected to slow to about $300 billion next year, according to JPMorgan. The bank is estimating about $371 billion of issuance this year.

Borrowing costs at close to record lows have sent the default rate for U.S. speculative-grade debt to 2.5 percent in October from 3.6 percent a year earlier, Moody’s said Nov. 11.

‘Challenging Situation’

“It’s hard to get the market to back up substantially when default rates are as low as they are.” Acciavatti, the head of high-yield research at JPMorgan, said yesterday in a telephone interview. His team predicted a 2013 return of about 7.5 percent, compared with a 6.9 percent rise on the Bank of America Merrill Lynch high-yield index.

Morgan Stanley was the most bearish of Wall Street banks last year, predicting a 3.1 percent rise.

“It’s a challenging situation because we’re looking at improving growth, low defaults and rates likely rising,” Morgan Stanley’s Richmond said. “It’s not a terrible environment for high yield, but the issue really is the math.”

The banking empire that J. Pierpont Morgan built, known as the House of Morgan, was split in 1935 with the creation of Morgan Stanley, two years after Congress passed the Glass-Steagall Act to separate commercial and investment banks amid the Great Depression.

Bank of America Corp., the second-largest underwriter of the securities, expects a 4 percent to 5 percent return because of the risk of higher interest rates, according to a Nov. 26 report from analysts including Michael Contopoulos in New York.

Microsoft Bonds

He said the debt won’t be able to absorb higher rates. The gap in yield between the securities and government debt has shrunk by 115 basis points since year-end to 419 basis points as of Dec. 2, according to Bank of America Merrill Lynch index data. Spreads reached this year’s high of 534 basis points in June.

Elsewhere in credit markets, Microsoft Corp. (MSFT:US) sold $8 billion of bonds in dollars and euros in its biggest offering ever. Invesco Mortgage Capital Inc. (IVR:US) bought all of the residential mortgage-backed securities created last month in a $300 million deal without government backing. Russian coal producer OAO Mechel (MTLR) won a waiver from banks to delay payments on a $1 billion loan until 2015 and 2016.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, decreased 0.37 basis point to 9.38 basis points. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

Bondholder Protection

The cost of protecting corporate debt from default in the U.S. rose to the highest level in more than a week. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, climbed 0.9 basis point to a mid-price of 70.5 basis points, the highest since Nov. 21, according to prices compiled by Bloomberg.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings was little changed at 80.7 at 10:41 a.m. in London. The Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan declined 0.3 to 136.

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 of debt.

Redmond, Washington-based Microsoft split its offering between 3.5 billion euros ($4.8 billion) of bonds in eight- and 15-year portions and $3.25 billion of dollar-denominated five-, 10- and 30-year notes, according to data compiled by Bloomberg. Corporate borrowers are paying 1.14 percentage points less to borrow in euros than dollars for borrowings of five to 10 years; two years ago, the relationship was reversed, with euro yields eclipsing dollar rates by 1.2 percentage points.

Invesco Deal

“The euro market is much cheaper than the dollar market today,” Microsoft Treasurer George Zinn said in an e-mailed response to questions. “We are being opportunistic and looking at rates across the globe. We can use the proceeds from these bonds for any general, domestic purpose.”

Invesco was attracted to potentially higher returns on the slices created after other investors pulled back, according toBill Hensel, a spokesman for the Atlanta-based real-estate investment trust. The purchases in the fifth transaction this year created out of prime-jumbo U.S. home loans for Invesco Mortgage by Credit Suisse Group AG (CS:US) represent a switch from REITs’ typical strategy of acquiring just the highest-yielding, junior-ranking slices in such deals.

The S&P/LSTA U.S. Leveraged Loan 100 Index fell 0.01 cent to 98.14 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 4.6 percent this year.

Mechel Loan

Mechel’s lenders including ING Bank NV, Societe Generale SA, UniCredit SpA and VTB Group agreed to the grace period for about $600 million in payments that had been due this year and next, according to a statement.

Russia’s largest producer of coking coal for steelmakers, controlled by billionaire Igor Zyuzin, is among the country’s most indebted mining companies, with the ratio of net debt to earnings before interest, taxes, depreciation and amortization at about 10.9 times in the first quarter, ING said in a report last month.

In emerging markets, relative yields widened 1 basis point to 359 basis points, or 3.59 percentage points, according to JPMorgan’s EMBI Global index. The measure has averaged 316.4 this year.

To contact the reporter on this story: Matt Robinson in New York at mrobinson55@bloomberg.net

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


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