Junk Bonds Buck Debt Slump With Tightest Spreads Since '08: Credit Markets

Junk bonds are becoming a haven for fixed-income investors roiled by mounting losses in government, investment-grade corporate and municipal debt.

Gains of 0.8 percent this month on high-yield, high-risk bonds compare with losses of 1.9 percent for Treasuries, 1.5 percent on high-grade company notes and 1.4 percent on state and local debt, according to Bank of America Merrill Lynch index data. Relative yields on junk bonds versus higher-rated corporates narrowed to 388 basis points, or 3.88 percentage points, a level that hasn’t been breached in three years.

“Junk bonds have benefited greatly by the fact that they’re the only place in the fixed-income world you can get some nice return,” said Dan Sheppard, a New York-based director in fixed-income at Deutsche Bank AG’s Private Wealth Management unit, where he helps oversee $12 billion.

Bonds of borrowers from credit-card processor First Data Corp. to Camp Hill, Pennsylvania-based Rite Aid Corp. are gaining as Pacific Investment Management Co. raises its forecast for U.S. growth next year. Other debt is tumbling after President Barack Obama agreed this week to extend tax cuts enacted under his predecessor and Federal Reserve Chairman Ben S. Bernanke said the central bank may expand bond purchases, spurring speculation inflation will accelerate.

“If you have a rising interest-rate environment, that’s a great environment for high yield,” said Zane Brown, fixed- income strategist at Jersey City, New Jersey-based Lord Abbett & Co., which manages $53 billion of debt.

Issuance Doubles Average

Novelis Inc., the Atlanta-based aluminum unit of India’s Hindalco Industries Ltd., and Australia’s Fortescue Metals Group Ltd. led $12 billion of junk-rated corporate bond issuance in the U.S. this week, the most since September, and more than double the 2010 weekly average of $5.65 billion, according to data compiled by Bloomberg.

Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar maturity government debt fell 1 basis point to 171 basis points, down from this year’s high of 201 in June, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Yields averaged 3.936 percent.

The cost of protecting bonds from default in the U.S. declined for the eighth straight day, the longest such streak since June. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, fell 0.2 basis point to a mid- price of 87.3 basis points as of 4:09 p.m. in New York, according to Markit Group Ltd.

Junk Bonds Gain

The index, which typically rises as investor confidence deteriorates and falls as it improves, is at the lowest since Nov. 5, when it ended at 85.6 basis points.

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 Barclays Capital Global Aggregate Index of bonds has lost 0.43 percent this month, trimming this year’s gain to 3.73 percent.

The gain on junk bonds brings returns for the year to 14.1 percent, after soaring a record 57.5 percent in 2009, according to Bank of America Merrill Lynch’s US High Yield Master II Index. Returns on the riskiest junk bonds, rated CCC or lower by S&P, have surged this month, gaining 1.9 percent.

Bonds from Atlanta-based First Data have gained 5.56 percent this month and drugstore chain Rite Aid added 2.65 percent, index data show.

The difference between spreads on junk and investment-grade debt last reached 388 basis points in June 2008 and fell below that level on Dec. 28, 2007, when it was 370 basis points, Bank of America Merrill Lynch indexes show. It was as wide as 1,531 basis points in December 2008 as credit markets froze after the collapse of Lehman Brothers Holdings Inc.

High-Yield Forecast

High-yield debt may return 6 percent next year, assuming a 75 basis-point rise in “risk-free rates,” Morgan Stanley analyst Adam Richmond wrote in a Dec. 8 report. If interest rates remain the same, the New York-based bank sees speculative- grade bonds earning 9.5 percent.

Junk bonds are likely to be the best performing fixed- income asset class next year, said Guy LeBas, chief fixed-income strategist and economist at Janney Montgomery Scott LLC in Philadelphia.

“Now that we’re through 2010, when falling yields drove increased prices across the bond spectrum, many investors are really looking towards higher spreads as the only way to earn outsized returns for 2011,” LeBas said. “You simply can’t get the kinds of returns investors are used to in investment-grade or Treasuries or other products.”

Tax Cuts

Government bonds tumbled for two days after Obama agreed on Dec. 6 to a two-year extension of current tax rates in exchange for another 13 months of federal unemployment insurance for the long-term jobless and cutting the payroll tax by $120 billion for one year.

Pimco, which manages the world’s biggest bond fund, sees the economy growing 3 percent to 3.5 percent in the fourth quarter of next year from the same period of this year. That compares with its previous estimate for 2 percent to 2.5 percent growth and the 2.2 percent gain forecast for this year by the International Monetary Fund.

“The U.S. is using fiscal and monetary policy to try to attain escape velocity for the economy,” Chief Executive Officer Mohamed El-Erian said in a telephone interview from his office in Newport Beach, California. “What we don’t know yet is whether that will be enough not just to change the economy’s trajectory for one year but to place it on a medium-term sustainable path.”

The average yield on junk debt of 7.93 percent compares with 4.12 percent on investment-grade bonds and 3.26 percent on the benchmark 10-year Treasury.

Sales Surge

Novelis issued $2.5 billion of notes in a two-part offering, the biggest since Oct. 6, and Fortescue Metals sold $1.5 billion through a unit after almost doubling the size of its transaction from $800 million, Bloomberg data show.

Speculative-grade debt sales this week surged to the most since the period ended Sept. 24, Bloomberg data show. Issuance fell to $1.56 billion, the lowest in almost three months, during the week ended Nov. 26 amid growing investor concern that Ireland’s debt crisis would spread to other European countries.

Companies continue to sell bonds to push back debt maturities rather than to reward equity holders, boosting the appeal of junk bonds, said George Goudelias, a director at Seix Investment Advisors LLC who co-manages the $1.8 billion Ridgeworth Seix Floating Rate High Income Fund.

“Even in the worse credits out there, everyone has bought time,” said Goudelias, who estimates high-yield spreads will tighten a further 50 basis points.

To contact the reporters on this story: Sapna Maheshwari in New York at sapnam@bloomberg.net; Tim Catts in New York at tcatts1@bloomberg.net

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

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