U.S. Bond-Swap Divide Evaporates in Stress Sign: Credit Markets

The gap between corporate bond yields in the U.S. and credit-default swaps is vanishing amid speculation the securities are too expensive following the biggest monthly rally since October and a slowing economy.

Relative yields fell this week to within 10 basis points of the corresponding cost of default insurance, from 275 basis points in 2008, according to JPMorgan Chase & Co. In Europe, swaps exceed bond rates by 43 basis points.

Investors seeking a haven from a slowing global economy and deepening turmoil in Europe are putting their money in U.S. company bonds, pushing returns last month to 2.49 percent through July 30, Bank of America Merrill Lynch index data show. The gains came even as the International Monetary Fund cut its global forecast and the Federal Reserve sees growth of less than 2 percent with unemployment above 8 percent.

“It’s an indication people are concerned about recession,” Michael Hampden-Turner, a strategist at Citigroup Inc. in London, said in reference to the rising cost of default insurance over relative yields on the bonds. “It’s usually an indication of stress.”

The amount of credit-default swaps outstanding on an index tied to U.S. investment-grade debentures has risen to cover a net $80.3 billion of debt, up from $77.3 billion at the end of June, according to the Depository Trust & Clearing Corp.

Briefly Inverted

The gap between bonds and swaps last approached zero in May and inverted briefly last year. In Europe, the divergence has grown amid concern a breakup of the single currency would cause economic shocks and as a shortage of corporate bonds combined with excess liquidity from central banks drove down yields.

“There’s demand for bonds given the fact it’s right now seen as the safe-haven universe,” said Jochen Felsenheimer, managing director in Munich at Assenagon Credit Management, which oversees 1.85 billion euros ($2.3 billion).

Elsewhere in credit markets, Ford Motor Co. sold $750 million of 3.5-year bonds in its second benchmark issue since regaining investment-grade ratings. Nissan Motor Co. sold $1.4 billion of bonds tied to auto loans at the lowest rate ever. Chinese oil and natural-gas explorer Cnooc Ltd. is said to be seeking about $5 billion in offshore financing from foreign banks to back its acquisition of Canada’s Nexen Inc.

Swap Spreads

The U.S. two-year interest-rate swap spread, a measure of stress in bond markets, rose for the first time in seven days, widening 0.77 basis point to 20.09 basis points. The gauge, which dropped 4.4 basis points in July for the second straight monthly decline, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, increased 1.3 basis points to a mid-price of 107.5 basis points, according to prices compiled by Bloomberg. The index fell 4.8 basis points in July after an 11 basis-point drop the previous month.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings was little changed at 160 basis points at 10:35 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan advanced 1 to 160. The gauge fell 11 basis points last month.

Itau Bonds

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.

Bonds of Itau Unibanco Holding SA were the most actively traded dollar-denominated corporate securities by dealers yesterday, with 201 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The company sold $1.375 billion of 5.5 percent, 10-year notes on July 30.

Ford, the second-largest U.S. automaker, issued 2.5 percent notes maturing January 2016 to yield 230 basis points more than similar-maturity Treasuries, Bloomberg data show.

Treasury Alternatives

The automaker issued $1.5 billion of 3 percent, five-year securities in June in its first benchmark sale after being upgraded to Baa3 by Moody’s Investors Service on May 22, Bloomberg data show. The move, which followed Fitch Ratings’s elevation of Ford from junk status on April 24, enabled the automaker to regain control of its logo and other assets pledged as collateral to obtain a $23.4 billion loan to keep the business going in 2006.

Nissan issued its top-rated securities with an average life of 1.49 years to yield 0.481 percent, the lowest financing rate for an auto company in the asset-backed market on record, according to data from Citigroup, the lead manager of the transaction. Though spreads on the debt were narrower in 2006, the higher lending benchmarks boosted the cost, the data show.

Issuance of asset-backed securities is surging as investors seek out safe alternatives to Treasuries, which recently reached record-low yields. Companies from Ford to JPMorgan have sold about $129 billion of securities linked to consumer and business borrowing this year, with auto debt accounting for $62 billion, excluding yesterday’s sale, Bloomberg data show.

Cnooc Funding

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index rose for a fourth day, climbing 0.09 cent to 94.46 cents on the dollar, the highest level since May 14. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, returned 1.59 percent in July, bringing its gain for the year to 6.56 percent.

Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s and lower than BBB- by S&P.

Cnooc, owned by the Chinese government and based in Beijing, is considering a bridge loan as well as longer-term financing of three or five years, according to two people familiar with the matter who asked not to be identified because the details are private. The company last month agreed to pay $15.1 billion in cash to acquire Nexen in the biggest overseas takeover by a Chinese company.

In emerging markets, relative yields narrowed 3 basis points to 342 basis points, or 3.42 percentage points, according to JPMorgan’s EMBI Global index. The measure has dropped from an almost five-month high of 440.6 on June 1.

Cash Deluge

The discrepancy between bonds and default swaps indicates a different kind of stress than that triggered by the collapse of Lehman Brothers Holdings Inc. in 2008, when investors dumped bonds, driving yields above the cost of insurance.

Now, the crisis in Europe, high unemployment rates and stalling growth in the U.S. as well as a slowdown in China, are prompting central banks to unleash an unprecedented flood of cheap cash, driving down sovereign debt yields as banks seek havens for the money. Yields on 10-year Treasuries are at about 1.5 percent and comparable German bunds offer 1.35 percent.

That’s boosting the attraction of corporate bonds. The extra yield investors demand to hold notes of all ratings globally decreased 18 basis points last month to 2.8 percentage points through July 30, the lowest level since May 8, Bank of America Merrill Lynch index data show. Spreads have tightened from 3.51 percentage points at year-end.

“The financial crisis was about solvency and liquidity,” said Tim Gately, head of European credit trading at Citigroup in London. “It’s not about liquidity this time around. There’s more liquidity than the market has ever seen.”

‘Spillover Effects’

The Fed’s balance sheet assets have grown to $2.85 trillion from less than $1 trillion in 2008, while European Central Bank President Mario Draghi has cut the ECB’s benchmark interest rate twice, to 1 percent, and expanded its balance sheet to more than 3 trillion euros since assuming office Nov. 1.

“Managers continue to get cash in and there’s nowhere else to go with the money,” Gately said. “CDS are much more driven by hedging and accounts trading the market momentum.”

The IMF cut its 2013 global growth forecast to 3.9 percent from the 4.1 percent estimate in April, and Fed Chairman Ben S. Bernanke warned that Europe’s financial woes are creating “spillover effects” in the rest of the world.

Safeway, Dell

The prospect of distortion in U.S. credit markets is indicated by the gap between default swaps and JPMorgan’s measure of yields linked to about 1,000 securities of more than 200 American companies. Yields are based on the so-called the z- spread, which is the extra yield investors demand to hold bonds over the bank swap rate.

Yields on investment-grade bonds in the U.S. fell to a record low 3.037 percent on July 30, according to the Bank of America Merrill Lynch U.S. Corporate Master index.

Swaps on Safeway Inc., the second-largest U.S. grocer, exceed the z-spread on bonds due in 2021 by 123 basis points. Dell, the Round Rock, Texas-based computer maker, has a positive basis of 62 basis points, while the gap on electronics chain Best Buy is at a record 403 basis points.

The basis is so positive for some companies “that it’s much more efficient” to bet against the cash bond market, Gately said. Analysts at Morgan Stanley and JPMorgan also recommend selling bonds and selling default swaps or using so- called credit-linked notes to profit from the gap.

The discrepancy in Europe is too high and should shrink whether the crisis worsens or improves because investors would remove hedges in a rally, while bonds would be caught up in a selloff, according to Saul Doctor, a credit strategist at JPMorgan in London.

“Though investors may be bearish, they do not want to sell cash bonds unless really forced to, due to the worry that they would find it difficult to buy them back at a later date and could possibly miss out on any rally,” Doctor said. “Instead, investors are hedging themselves by buying CDS protection.”

To contact the reporter on this story: Abigail Moses in London at Amoses5@bloomberg.net

To contact the editor responsible for this story: Paul Armstrong at Parmstrong10@bloomberg.net

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