Bond-to-Stock Shift Provokes Performance Anxiety: Credit Markets

Photographer: Scott Eells/Bloomberg

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Photographer: Scott Eells/Bloomberg

Traders work on the floor of the New York Stock Exchange.

Investment-grade bonds in the U.S. are underperforming equities by the most in 15 months as speculation rises that the time is ripe to rotate out of debt and into stocks.

The notes, which have lost 0.1 percent since the end of October after gaining 56 percent from the start of 2009, are lagging behind the Standard & Poor’s 500 index by 4.3 percentage points in January, the most since October 2011. Investors yanked $5.5 billion from funds that invest in the bonds in the six weeks ended Jan. 9 while pouring $47.6 billion into equities, according to research firm EPFR Global in Cambridge, Massachusetts.

An unprecedented flood of $285.5 billion into bond funds in the U.S. last year sent yields to all-time lows, helping borrowers raise $1.5 trillion selling notes and providing cash to the neediest companies that would otherwise default. Diminished demand for debt may raise corporate borrowing costs, providing headwinds to efforts by the Federal Reserve to spur an economy struggling with an unemployment rate above 7 percent.

“We’re slowly, incrementally shifting into other assets,” William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts, said in a telephone interview. “The real return is going to be negative for a lot of these fixed-income investments. It’s a very dangerous asset class right now.”

‘Bond Bubble’

Investors, repelled by a 38 percent decline in stocks in 2008, have sought refuge in bonds, undeterred as the U.S. was stripped of its top credit grade by S&P in August 2011 and as lawmakers risked putting the nation into recession in budget negotiations this month. Declining yields create the potential for a “bond bubble” in which rising interest rates may prompt losses, Fitch Ratings said in a Dec. 19 report.

Yields on investment-grade bonds dropped to a record low 2.73 percent on Nov. 8, compared with their 10-year historic average of 5.02 percent, before rising to 2.77 percent as of Jan. 18.

As bond buyers pull back, the extra yield investors demand to hold investment-grade bonds rather than government debentures has flattened after reaching a 20-month low on Jan. 7. Spreads expanded 2 basis points in the past week to 147 basis points.

Making Money

“There’s only so much more for high-grade spreads to tighten in,” said Elaine Stokes, a money manager who helps oversee the $22.8 billion Loomis Sayles Bond Fund. “Do the math. How can you actually make money there?”

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. climbed. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 0.6 basis point from Jan. 18 to a mid-price of 87.7 basis points as of 11:25 a.m. in New York, according to prices compiled by Bloomberg. The benchmark has climbed from 84.9 on Jan. 7, the least since Sept. 14. Bond markets were closed yesterday for the Martin Luther King Jr. holiday.

The measure typically rises as investor confidence deteriorates and falls as it improves. The contracts 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 Swaps

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.3 basis point to 14.45 basis points as of 11:26 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of General Electric Co. (GE) are the most active dollar- denominated corporate securities today, accounting for 5.4 percent of the volume of dealer trades of $1 million or more as of 11:27 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Investment-grade bonds in the U.S. are little changed this month with a 0.005 percent gain following declines of 0.02 percent in December and 0.08 percent in November, Bank of America Merrill Lynch index data show.

The performance compares with posted gains on the S&P 500 index of 4.28 percent, including reinvested dividends. The outperformance by stocks is the largest since October 2011, when equities gained 10.93 percent and the debt returned 1.75 percent.

‘Great Rotation’

“A ‘great rotation’ of sorts has played out within credit,” wrote Bank of America Corp. credit strategists Barnaby Martin, Teo Lasarte and Ioannis Angelakis in a Jan. 10 report.

Speculative-grade bonds, rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P, have returned 3.9 percent since October, compared with a 0.1 percent loss on investment-grade notes, as investors seek higher-yielding assets, Bank of America Merrill Lynch index data show. U.S. Treasuries have declined 0.3 percent.

The withdrawals from investment-grade bond funds mark the longest stretch of outflows since the period ended February 2011, according to EPFR data. The equity deposits include a $22.2 billion inflow in the week ended Jan. 9, the second-most ever.

Investors have sought riskier assets with the Fed holding its benchmark interest rate at zero to 0.25 percent since December 2008 and injecting more than $2.3 trillion into the financial system through bond purchases to ignite economic growth following the worst financial crisis since the Great Depression.

Unemployment Rate

The economy is expected to grow 2.8 percent in 2014, after a gain this year of 2 percent and 2.3 percent in 2012, according to the average estimate of 96 analysts surveyed by Bloomberg.

“The market is looking at the economic situation to sort of gauge, ‘Should I get close to the sell trigger?’” Cabot’s Larkin said. “Sometimes recoveries occur unexpectedly and changes happen rapidly. That could happen this time; we could see a pretty big shift into equities from high-quality fixed- income.”

A rotation into stocks may threaten Fed Chairman Ben S. Bernanke’s plan to hold borrowing costs low until the unemployment rate falls below 7 percent from its current 7.8 percent.

Risks loom for the economy as lawmakers seek to address the nation’s debt limit. The Treasury Department has said the U.S. will exceed its $16.4 trillion borrowing authority sometime from mid-February to early March.

Liquidity Conditions

“As long as we stay in an environment where people still feel like there is risk on the table, in so far as the fiscal debate goes, I think you’ll still see fixed-income funds garner a fair amount of attention,” Scott Kimball, a money manager at Taplin Canida & Habacht LLC, a BMO Financial Group unit that oversees $7.4 billion, said in a telephone interview. “The toggle is going to be the outcome from Capitol Hill.”

After raising an unprecedented $1.1 trillion in 2012, investment-grade companies have seen sales soar 22 percent this month from the corresponding period to $102.4 billion, according to data compiled by Bloomberg. Issuance of $49.1 billion in the five days ended Jan. 11 marked the busiest week since March.

Offerings will drop in the second half of the year, leading to a 16 percent decline in high-grade 2013 sales because of rising interest rates and less favorable liquidity conditions, analysts led by Hans Mikkelsen at Bank of America wrote in a Dec. 3 report. Also, many borrowers have already met their needs in the bond market, they wrote.

‘Somewhere Else’

Investment-grade bonds are about the most expensive relative to stocks ever, with the yield-to-worst on the debt dropping to 2.76 percent on Jan. 17, according to the Barclays U.S. Aggregate Corporate index. That compares with an earnings yield of 6.78 percent for the S&P 500 index. (SPX)

The Barclays yield to worst reached a record 4.65 percentage points below the earnings yield on the S&P 500 index on Nov. 14.

In the 10 years before Lehman Brothers Holdings Inc. filed for bankruptcy protection in September 2008, the earnings yield on stocks was an average 1.08 percentage points less than the yield on the debt.

“I’m not surprised that money is starting to come out of investment-grade bond funds given the big rally they’ve had,” Loomis Sayles’s Stokes said. ‘There’s an understanding that you need to go somewhere else to get return. You’re not going to be able to outrun rates.”

To contact the reporters on this story: Sarika Gangar in New York at sgangar@bloomberg.net; Lisa Abramowicz in New York at labramowicz@bloomberg.net

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

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