Bloomberg News

Taper Defied With Bond Spreads Least Since ’07: Credit Markets

December 06, 2013

Corporate-bond buyers are accepting the lowest relative yields since before the 2008 financial crisis to own dollar-denominated notes that face declining returns as the Federal Reserve considers paring record stimulus.

The extra yield investors demand to own debt of the most-creditworthy to riskiest borrowers instead of similar-maturity Treasuries has narrowed 31 basis points this year to 200 basis points, the lowest since October 2007, according to Bank of America Merrill Lynch index data. UBS AG sees losses for investment-grade debt next year even as spreads continue to contract.

The Fed is pushing investors into riskier securities by adding to the more than $3 trillion it’s pumped into the financial system through asset purchases the past five years. By pushing spreads below the average of the 10 years before 2008, bond buyers are leaving themselves more vulnerable to a potential surge in yields on U.S. Treasuries when the central bank starts curtailing its $85 billion of monthly debt purchases.

“At these spread levels, this is a hope trade,” said Mark McDonnell, a money manager who helps oversee $1.3 billion at Hillswick Asset Management LLC in Stamford, Connecticut. The firm is “underweight” corporate bonds, meaning it holds a smaller percentage of the debt than contained in benchmark bond indexes. “You’re hoping they get tighter and don’t get hit when rates rise.”

2013 Loss

Corporate bonds are poised for their first annual loss since 2008 after gaining a total 66 percent in the previous four years, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Index.

The almost $6 trillion of debt in the index, with an average maturity of nine years, has lost an annualized 0.1 percent in 2013. Average yields, which reached an unprecedented low of 3.35 percent in May, have since climbed to 4 percent, up 42 basis points for the year.

The debt lost almost 11 percent in 2008.

Spreads on investment-grade debt in the U.S. may narrow an additional 15 basis points next year, while junk bonds may contract another 20, UBS analysts led by Matthew Mish wrote in a Dec. 4 report. Switzerland’s biggest bank last month forecast a 2014 return of 2.1 percent for the speculative-grade debt and a 0.9 percent loss for investment-grade securities.

Eroded Cushion

“The bottom line is that people have a lot of cash, and there’s a willingness to put it to work,” Mish said in a telephone interview. “I’m not saying that’s the prudent thing to do, but irrespective of the return forecast we have for next year, there’s a significant feeling that people need to earn more than zero.”

Spreads on U.S. investment-grade and junk bonds have contracted by almost 700 basis points from a peak of 896 in December 2008, about three months after the collapse of Lehman Brothers Holdings Inc. helped spark a seizure in credit markets, Bank of America Merrill Lynch index data show.

After average annual returns of 10.8 percent since the end of 2008, investors have been left with spreads that are 8 basis points below the average 208 basis points during the 10 years ended 2007, the index data show. That may leave investors with too thin of a cushion against losses should benchmark interest rates climb.

‘Wonderful Place’

“Credit in aggregate has been a wonderful place to be over the last four years,” Gibson Smith, chief investment officer of fixed income at Janus Capital Group, which manages about $28 billion in assets, said in a telephone interview from Denver. “There are fewer opportunities today than there were even just a year ago.”

Yields on 10-year Treasuries touched an 11-week high of 2.88 percent yesterday after reports showing the economy expanding faster than economists had estimated and jobless benefits declining more than forecast stoked speculation the Fed will slow bond purchases as soon as this month. Central bank policy makers meet Dec. 17-18.

Concern that rising interest rates will erode returns has fund managers favoring corporate debt over government-backed securities by the most since 2009, according to data from the Investment Company Institute, a Washington-based trade group, whose members oversee $16.1 trillion. Money managers have added $35.1 billion to company-bond funds and pulled $9.1 billion from those that invest in taxable bonds issued or backed by the U.S. government.

Cutting Leverage

Demand for corporate debt also reflects the improved finances of borrowers, according to Gregory Kamford of Royal Bank of Scotland Group Plc.

“Corporates are still fundamentally sound,” Kamford, a macro credit strategist at RBS in Stamford, Connecticut, said in a telephone interview. “The corporate sector is in better health today than it was the last time spreads reached these levels, so in a sense current spreads are more justifiable.”

Companies in the Standard & Poor’s 500 Index have trimmed leverage since the financial crisis, reducing debt loads to 3.5 times earnings before interest, taxes, depreciation and amortization from an average of 5.4 times in 2007, according to data compiled by Bloomberg.

Credit Benchmarks

“I still think you can favor corporates,” said Thomas Urano, a money manager at Austin, Texas-based Sage Advisory Services Ltd., which oversees about $10 billion. “You’ll get the extra carry and the only way that nominal rates continue to march higher is if the economy does show signs of growth and acceleration,” which would aid spread contraction and help to counter the effect of rising rates.

Elsewhere in credit markets, a gauge of U.S. company credit risk fell after employers added more workers than forecast in November and the jobless rate dropped to a five-year low of 7 percent.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 2.4 basis points to a mid-price of 70 basis points as of 10:20 a.m. in New York, according to prices compiled by Bloomberg.

The 203,000 increase in payrolls followed a revised 200,000 advance in October, the strongest back-to-back gain since February-March, Labor Department figures showed today in Washington. The median forecast of 89 economists surveyed by Bloomberg called for a 185,000 advance.

Rate Swaps

The swaps index typically falls as investor confidence improves and rises 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.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell 0.25 basis point to 8.5 basis points. The gauge typically narrows when investors favor assets such as corporate debt and widens when they seek the perceived safety of government securities.

Bonds of Goldman Sachs Group Inc. (GS:US) are the most actively traded dollar-denominated corporate securities by dealers, accounting for 5.3 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

To contact the reporters on this story: Charles Mead in New York at cmead11@bloomberg.net; 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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