Goldman, Morgan Stanley Diverge on Purchasing Junk Bonds: Credit Markets

Morgan Stanley says investors should buy the lowest-rated corporate debt, while Goldman Sachs Group Inc. says stay away, underscoring the dilemma faced by investors as junk-bond prices rise to the highest since 2007.

Bonds graded CCC in the U.S. are the “cheapest” high- yield securities with “economic data once again beginning to surprise to the upside,” Morgan Stanley told clients yesterday in a report. Goldman Sachs says higher-rated speculative-grade debt is the way to go as the economy decelerates.

Bondholders faced with near-zero interest rates and record- low yields are turning to higher-risk notes to boost returns, betting growth will be strong enough to keep defaults in check. Investors poured $480.2 billion into mutual funds that focus on debt in the two years ended June 30, more than went into stock funds during the Internet bubble, according to the Washington- based Investment Company Institute. That has helped companies sell a record amount of junk bonds in 2010 with three months still left in the year.

“A lot of very mediocre to marginal deals have been able to get out of the gate over the last few months because there’s still tremendous risk appetite,” said Margaret Patel, who oversees about $1 billion of assets at Wells Fargo & Co.’s Advantage Diversified Capital Builder Fund and Advantage Diversified Income Builder Fund in Boston. “The economy is at least growing slowly, but it’s growing positively, so that’s a very, very favorable backdrop for high yield.”

Prices Climb

Prices of U.S. corporate bonds rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s closed at an average of 100.4 cents on the dollar yesterday, up from 55 cents in December 2008, according to Bank of America Merrill Lynch index data.

The lowest-ranked debt, rated CCC and lower, has done even better, rising to 89.2 cents from 31.6 cents. The securities have returned 3 percent this month, with relative yields averaging 10.9 percentage points more than Treasuries.

While the securities are beating BB debt by 0.94 percentage point this month, they’re trailing for the year. The highest tier of junk debt has gained 12.4 percent this year compared with 10.4 percent for bonds rated CCC and lower, Bank of America Merrill Lynch index data show.

Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar-maturity government debt rose 1 basis point to 172 basis points, or 1.72 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 3.476 percent, the lowest since reaching the same level Aug. 31.

The cost of insuring Irish debt against default surged to a record as the government auctioned bills, while Microsoft Corp. sold bonds yesterday at the lowest interest rates on record as September issuance continued to surge. Private equity firm KKR & Co. issued notes for the first time.

Microsoft Offering

Microsoft, one of only four non-financial companies rated AAA by S&P and Moody’s, issued $4.75 billion of debentures one day after boosting its dividend and getting board approval to sell debt. The world’s biggest software maker, based in Redmond, Washington, raised $1 billion from 0.875 percent three-year debt, $1.75 billion from 1.625 percent five-year debentures, $1 billion from 3 percent notes due 2020 and $1 billion from 4.5 percent bonds maturing in 2040, Bloomberg data show.

The coupon on the three-year security is less than the 1 percent on a similar-maturity note issued last month by International Business Machines Corp., which was previously the lowest of the more than 3,500 securities in the Barclays Capital U.S. Corporate Index of investment-grade company debt.

KKR Bonds

KKR, which began trading on the New York Stock Exchange in July, boosted its offering of 10-year senior unsecured notes to $500 million from $350 million. The notes yield 387.5 basis points more than Treasuries, Bloomberg data show.

The New York-based firm, founded by Henry Kravis and George Roberts in 1976, raised the cash as it expands beyond traditional buyouts, in which it pools money from investors to take over companies, and into capital markets, underwriting equity and bond offerings.

Credit-default swaps insuring Ireland’s sovereign debt surged 31 basis points to an all-time high 495.5, according to data provider CMA.

Ireland sold 300 million euros of securities due February 2011 today at an average yield of 1.907 percent, compared with 1.925 percent at a Sept. 9 sale, according to the nation’s debt agency. It also issued 100 million euros of April 2011 securities at an average yield of 2.231 percent, up from 2.19 percent.

Corporate Risk

A benchmark indicator of corporate credit risk in the U.S. climbed for a third day. Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, increased 1.6 basis points to a mid-price of 112.95 basis points as of 10:07 a.m. in New York, according to index administrator Markit Group Ltd.

Credit-default 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 swap protecting $10 million of debt.

Concern the U.S. economy will falter led the Federal Reserve to say Sept. 21 it’s willing to ease monetary policy further to spur growth. Fed policy makers said the pace of recovery and job growth have “slowed in recent months.” The central bank has kept its target rate for overnight loans between banks in a range of zero to 0.25 percent since December 2008.

Gross Domestic Product

Morgan Stanley forecasts annualized growth in gross domestic product of 2 percent to 2.5 percent in the second-half of this year.

“That typically has been an ideal environment for credit,” Adam Richmond, a credit strategist at Morgan Stanley in New York, said yesterday. “Unless you really think that we’re going to double dip, even in zero to 2 percent growth, we find that high yield holds up OK, even the lower quality bucket.”

Moody’s said this week the number of U.S. companies at greatest risk of default dropped to the lowest level in two years. Companies rated at or below B3 with a negative outlook declined to 195 as of Sept. 1 from a high of 288 in June 2009. Clear Channel Communications Inc. and Energy Future Holdings Corp., formerly named TXU Corp., were among the biggest companies on the list.

Goldman Sachs economists estimate growth at 1.5 percent on an annualized basis this quarter, next quarter and in the first period of 2011, said Alberto Gallo, a credit strategist for the firm in New York. Goldman Sachs has favored BB corporate bonds over CCC debt since the end of 2009.

‘Deceleration’

“We do like high yield much more in the BB and B space,” Gallo said. “Because of the potential for deceleration in the economy in the second half of the year, as well as relatively compressed valuations, we prefer to be in the upper end of high yield.”

The average yield on CCC bonds is 12.3 percent, compared with BB debt that pays 6.5 percent, or a spread over Treasuries of 465 basis points, according to Bank of America Merrill Lynch index data.

“Lower-quality high yield to us is cheaper on a risk- adjusted valuation than higher-quality high yield,” Richmond said. “Over the next year or so, the right trade is to be long credit risk and short or neutral on rate risk. The best way to get the most credit exposure with the least rate exposure is in lower-quality high yield.”

Morgan Stanley estimates the 10-year Treasury note yield will rise to 3 percent this year and to 4.25 percent by the end of 2011, while Goldman Sachs forecasts 2.5 percent in December 2010 and 3.3 percent a year later. The yield closed at 2.56 percent yesterday in New York.

Sales Booming

Junk bond sales are booming. Speculative-grade debt issuance in the U.S. jumped to $187.3 billion this year compared with $100.1 billion in the same period of 2009, Bloomberg data show. Companies rated Caa1 or lower by Moody’s have issued at least $2.63 billion of bonds this month, compared with $2.56 billion in August and the most since April.

Goldman Sachs has underwritten 84 issues totaling $12.95 billion of high-yield U.S. offerings this year, 6.9 percent of the market and the sixth-highest amount, Bloomberg data show. Morgan Stanley is seventh, having helped manage 81 offerings for $12.7 billion of sales, or 6.8 percent of the market.

The firms helped underwrite Valeant Pharmaceuticals International’s two-part, $1.2 billion sale of senior notes on Sept. 21, Bloomberg data show.

Demand for the lowest debt is evident with Freescale Semiconductor Inc., bought in a 2006 leveraged buyout led by Blackstone Group LP, selling $750 million of notes yesterday after increasing the size of the offering from $500 million. The 10-year, 10.75 percent debentures are rated Caa2 by Moody’s and the equivalent CCC by S&P. The Austin, Texas-based chipmaker’s $1.265 billion of 8.875 percent notes due 2014 rose 2.94 cents to 100 cents on the dollar, Trace data show.

To contact the reporter on this story: John Detrixhe in New York at jdetrixhe1@bloomberg.net

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

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