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Junk Overtakes Stocks as Cash Inundates Funds: Credit Markets

Junk bonds are beating stocks by the most since September, with speculative-grade debt building on last month’s gains while losses deepen in equities, as investors seek a haven amid signs the economic recovery is slowing.

Junk bonds have returned 8.3 percent this year through yesterday, exceeding the 7.2 percent gain for stocks. The notes have returned 0.51 percent this month, building on April gains of 0.73 percent, Bank of America Merrill Lynch index data show. Stocks have lost 3.2 percent in May, after declining 1.11 percent, according to the MSCI All-Country World Index.

Bonds are drawing cash with the lure of the best returns as service industries in the U.S. expand less than projected and a backlash against austerity measures in Europe drag down the region’s economy. Returns this year on junk notes, trading above par for the first time since August, are more than double last year’s gains of 3.1 percent.

“The concern in the market is that some of the strong inflows that we’ve been seeing in recent weeks and months have been chasing that performance, which is impossible to replicate,” Oleg Melentyev, a credit strategist at Bank of America Merrill Lynch Global Research in New York, said in a telephone interview.

Funds that buy speculative-grade debt reported $1.84 billion of inflows in the week ended May 2, with more than 85 percent of the cash going toward U.S. high yield, data compiled by Cambridge, Massachusetts-based EPFR show. That’s the most since the week ended Feb. 15, when the funds recorded $2.25 billion.

‘Scared of Equities’

Junk bond returns of 107 percent since the end of 2008 are double the 53 percent gain in stocks worldwide.

“Look at the alternatives,” said Gershon Distenfeld, who oversees high-yield credit investments at AllianceBernstein LP (AB) in New York. “People are scared of equities. They’re very volatile. High yield looks pretty good on a risk-adjusted basis.”

Elsewhere in credit markets, a benchmark gauge of U.S. company credit risk rose for a fifth day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing by 2.4 basis points to a mid-price of 103.3 basis points as of 12:34 p.m. in New York, according to prices compiled by Bloomberg.

That’s the highest level since April 11 on an intra-day basis for the index, which typically rises as investor confidence deteriorates and falls as it improves. 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 contract protecting $10 million of debt.

Rate Swap Spreads

The U.S. two-year interest-rate swap spread, a measure of bond market stress, rose for a sixth day, climbing 2.6 basis points to 33.8 basis points as of 12:34 p.m. in New York. The gauge, at the highest level since Jan. 30 on an intra-day basis, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Bonds of Diageo Plc are the most actively traded dollar- denominated corporate securities by dealers today, with 111 trades of $1 million or more as of 12:29 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The world’s biggest distiller sold $2.5 billion of bonds yesterday in a three-part offering.

Junk Advantage

The 3.75 percentage-point advantage in returns for junk bonds over stocks is the biggest since September, when the Bank of America Merrill Lynch Global High Yield index lost 3.7 percent and MSCI All-Country World Index tumbled 9.4 percent.

Spreads on high-yield bonds have declined to 653 basis points from 807 basis points at year-end, Bank of America Merrill Lynch index data show.

Investors are plowing money into the riskiest debt as the U.S. economic recovery stumbles, favoring bonds over stocks, and default rates remain below the historic average.

The U.S. economy will grow 2.3 percent through December, following expansions of 1.7 percent last year and 3 percent in 2010, according to the median estimate of 74 analysts surveyed by Bloomberg.

Trading Above Par

With speculative-grade companies reporting “healthy” profits in the first quarter, that’s “the right recipe for high-yield investors,” JPMorgan Chase & Co. analysts led by Peter Acciavatti in New York wrote in a May 4 report.

Moody’s Investors Service’s liquidity-stress index fell to 3.9 percent in April, matching a record-low level last seen in August, the New York-based ratings company said on May 2.

Average high-yield bond prices rose above 100 cents on the dollar for the first time in eight months on May 3, Bank of America Merrill Lynch index data show.

“Further capital gains in this market are going to be limited,” Melentyev said.

Spain, Greece, Italy and Portugal have slid into recession and Nicolas Sarkozy this weekend became the first French president in 30 years to fail to win re-election amid a region- wide backlash against austerity. In Greece’s election, the results cast doubt on whether the two main parties, New Democracy and Pasok, can form a coalition to implement spending cuts to ensure the flow of bailout funds after data showed euro- region services and manufacturing output contracted more than estimated in April, adding to signs of a deepening economic slump.

Default Rate

An index that measures the expansion of U.S. service industries fell to a four-month low of 53.5 in April from 56 in March, the Institute for Supply Management said May 3. That day, the MSCI All-Country World Index (MXWD) lost 0.5 percent while high- yield bonds gained 0.16 percent, Bank of America Merrill Lynch index data show.

U.S. corporate bonds “are still the best house in a bad neighborhood,” said Bonnie Baha, head of the global developed credit group at DoubleLine Capital LP in Los Angeles, where she helps oversee $34 billion. “Where else are you going to go with your money?”

The trailing 12-month global speculative-grade corporate default rate rose 0.1 percentage point last month to 2.6 percent, Moody’s said yesterday. While that compares with 2.4 percent a year earlier, it’s below the historical average of 4.8 percent since 1983.

The junk market is “becoming more mainstream and the hunt for yield is aiding that process,” said Michael Anderson, a U.S. high-yield strategist at Citigroup Inc. in New York. “The low default outlook has and will definitely reduce risk aversion.”

To contact the reporters on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net; Heather Perlberg in New York at hperlberg@bloomberg.net

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

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