Risk is being turned on its head in the corporate-bond market as debt deemed closest to default beats returns on the highest-rated debentures by the most in four years.
Securities ranked in the CCC tier or lower by Standard & Poor’s have gained 7.1 percent this year, compared with a 5 percent loss for AAA rated debt, according to Bank of America Merrill Lynch index data. AAAs are losing 1.2 percent this month, versus 0.5 percentage point for CCCs. The divergence is making this only the third year since at least 1996 in which the lowest-graded debt produced gains while top-rated bonds lost, the data show.
Investors are eschewing bonds with the most to lose when interest rates rise as the Federal Reserve signals it may soon begin pulling back from unprecedented stimulus. A measure of sensitivity to changes in benchmark rates is at about a record high for AAA bonds, while it is holding below the average over the past 10 years for CCC debt, the Bank of America Merrill Lynch index data show.
“It’s a perfect storm,” Stefan Lingmerth, a New York-based analyst with Phoenix Investment Adviser LLC, a distressed-debt investor, said in a telephone interview. “AAAs are more interest-rate sensitive, while CCCs are hardly affected,” and investors are looking for more yield as the economic recovery strengthens, he said.
Speculative-grade companies have issued $241.6 billion of the bonds in the U.S. this year, on pace to exceed the record $357.3 billion of sales last year, according to data compiled by Bloomberg. Debt from companies in the lowest ratings tier account for about a third of the $14.7 billion issued this month, up from 18 percent in July.
The bond market has been roiled ever since Fed Chairman Ben S. Bernanke outlined a plan in May that would start cutting the central bank’s $85 billion of bond purchases later this year if the world’s largest economy continues to improve.
Unsecured debt from Eden Prairie, Minnesota-based Supervalu Inc. (SVU), which is rated Caa1 by Moody’s Investors Service, has gained 30.4 percent this year through Aug. 27, while bonds of Johnson & Johnson (JNJ), the world’s largest maker of healthcare products, have declined 5.3 percent, Bank of America Merrill Lynch index data show.
The interest-rate sensitivity measure, known as effective duration, has climbed to 8 for all AAA rated debt and reached a record 8.2 reached last month, Bank of America Merrill Lynch index data show. The gauge, which is up from 5.7 at the end of 2008, compares with 3.8 for CCC graded bonds.
“Being long fixed-income duration” has worked for a lot of investors who are “now starting to rotate out of that,” Jon Duensing, head of corporate credit at Smith Breeden Associates, said in a telephone interview from Boulder, Colorado. “High-yield debt tends to have less interest-rate sensitivity.”
Elsewhere in credit markets, regulators proposed easing a measure to require lenders to keep a stake in mortgages that they securitize, an effort designed to discourage the kind of risky loans that contributed to the subprime credit crisis. Sanofi, France’s largest drugmaker, sold its first bonds in euros since November. Akorn Inc. (AKRX), a maker of generic eye-care products, obtained $675 million of financing commitments backing its purchase of Hi-Tech Pharmacal Co.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, fell for the first time this week, declining 0.4 basis point to a mid-price of 83.4 basis points, according to prices compiled by Bloomberg.
The Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, fell 1.9 to 104.5 basis points at 10:30 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan fell two basis points to 165.
The indexes typically fall as investor confidence improves and rise as it deteriorates. 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 U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell 1.7 basis points to 16.19 basis points, the lowest since July 29. The gauge typically narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Fairfield, Connecticut-based General Electric Co. were the most actively traded dollar-denominated corporate securities by dealers yesterday, accounting for 4.6 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Paris-based Sanofi offered 1 billion euros ($1.3 billion) of 1.875 percent, seven-year securities to yield 27 basis points more than swaps, Bloomberg data show.
The 505-page draft risk-retention regulation written by six agencies drops a requirement that lenders retain a stake in mortgages with down payments of less than 20 percent, which appeared in an earlier version of the measure known as the qualified residential mortgage rule. The first draft, released in 2011, drew protests from housing industry participants and consumer groups who said it would impede home lending.
The draft would align the qualified residential mortgage rule, designed to protect investors, with similarly named guidance governing risky home lending: the qualified mortgage, or QM rule, designed to protect borrowers. That regulation, issued by the Consumer Financial Protection Bureau in January, contains no down payment requirement. It offers legal protections to banks that make loans defined by the rule as non-abusive.
The S&P/LSTA U.S. Leveraged Loan 100 Index fell 0.02 cent to 97.62 cents on the dollar, declining for the 10th straight day to the lowest level since July 9. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 2.92 percent this year.
Leveraged loans and high-yield, high-risk, or junk bonds are rated below Baa3 by Moody’s and lower than BBB- at S&P.
Akorn’s proposed credit pact consists of a $600 million term loan and a $75 million revolving credit line, according to a regulatory filing yesterday. JPMorgan Chase & Co. is providing the debt commitments.
The seven-year term loan will help fund the $640 million Hi-Tech deal, which the company expects will be completed in the first quarter of 2014, while the five-year revolver will be used by Lake Forest, Illinois-based Akorn for general corporate purposes, according to the filing. Under a revolver, money can be borrowed again once it’s repaid; in a term loan, it can’t.
In emerging markets, relative yields narrowed 3 basis points to 373 basis points, or 3.73 percentage points, according to JPMorgan’s EMBI Global index. The measure has averaged 304.6 basis points this year.
Rising yields on benchmark Treasuries (USGG10YR) are putting the highest-rated corporate bonds on pace for their biggest losses since at least 1989, surpassing a 3.6 percent loss in 1999, according to Bank of America Merrill Lynch index data.
Yields on 10-year Treasuries have climbed 1.14 percentage points to 2.77 percent since reaching a 2013 low of 1.63 percent on May 2. The extra yield investors demand to own AAA rated bonds instead of similar-maturity Treasuries has climbed 6 basis points to 70 basis points, the index data show.
Moody’s is forecasting that default rates for speculative-grade companies globally will end 2013 at 3 percent before dropping to 2.5 percent in July 2014.
Yields on the lowest-rated debt, which have gained 196 percent since the end of 2008, have declined to 10.3 percent from 10.97 at the end of 2012 and as high as 41.3 percent in December 2008.
“There’s a lot of interest-rate risk, particularly in the very highest-rated bonds,” said Martin Fridson, the chief executive officer of New York-based FridsonVision LLC, a research firm that specializes in high-yield debt. “There isn’t much reason to believe that credit risk is escalating at present, whereas Treasury yields have certainly shot up very sharply since the beginning of the year.”
The importance of holding a AAA rating in the corporate-bond market has lessened as interest rates fell to unprecedented lows. The number of non-financial AAA companies in the U.S. has dwindled to four from more than 60 in the early 1980s, according to S&P.
“We may very well be at the end of a 30-year decline in rates,” Fridson said. “So it could be a painful period for a while to come.”
To contact the reporter on this story: Matt Robinson in New York at Mrobinson55@bloomberg.net.
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