Bonds Rallying Most Since 2009 Mask Apprehension: Credit Markets

The biggest corporate bond-market returns since 2009 mask a growing sense of unease.

While the debt of companies from the U.S. to Europe and Asia has rallied every month this year, yield premiums have held steady in May. That signals the gains have almost nothing to do with whether investors have an improved outlook for credit or the economy.

Investors see little reason to bestow higher valuations on corporate bonds with absolute yields almost at record lows and central banks worldwide expressing concern that growth is slowing. The Paris-based Organization for Economic Cooperation and Development cut its forecast for global growth, saying in its a semi-annual report on May 6 that the world economy will expand 3.4 percent this year instead of the 3.6 percent predicted in November.

“Trees don’t grow to the sky; at some point you have to be a little more circumspect about your investing philosophy,” Bonnie Baha, director of global developed credit at Los Angeles-based DoubleLine Capital LP, which manages about $50 billion, said in a telephone interview. “Investors are becoming a bit more defensive.”

The extra yield that buyers demand to hold corporate bonds instead of government securities has narrowed two basis points this month to 167 basis points after falling from this year’s high of 193 basis points in early February, according to the Bank of America Merrill Lynch Global Corporate & High Yield Index. The spread was 165 basis points, or 1.65 percentage points, on May 13, the narrowest level since 2007.

Less Confident

“When it’s this expensive, I’m buying at a level that isn’t reasonable at historic norms,” William Larkin, a money manager who oversees $520 million in assets at Cabot Money Management in Salem, Massachusetts, said in a telephone interview.

Corporate bonds have returned 5.1 percent this year, the most for the equivalent period since gaining 5.7 percent in 2009, Bank of America Merrill Lynch index data show.

“If you believe that this environment is going to end at some point, it’s a trade, not an investment,” he said.

Global speculative-grade bond spreads widened to 398 basis points on May 28 after hitting a more than six-year low of 390 basis points on April 22, according to Bank of America Merrill Lynch index data. The excess return relative to sovereign bonds was 0.14 percent in May, the least since minus 0.55 percent in January.

Losing Steam

Yield premiums on investment-grade bonds may not decline much more, according to Barclays Plc strategists Jeffrey Meli and Bradley Rogoff. “One of the primary reasons that the rally may lose steam is that investment-grade industrials have releveraged,” they wrote in a research note on April 4.

The ratio of debt to earnings before interest, taxes, depreciation and amortization in the Standard & Poor’s 500 Index has climbed to 2.55 from 2.27 three years ago, according to data compiled by Bloomberg.

This year’s rally in the U.S. has been mainly attributable to bonds of industrial rather than financial companies, said Meli and Rogoff, who singled out the media sector, which has been helped by merger and acquisition activity, particularly Comcast Corp.’s $45 billion bid for Time Warner Cable Inc.

Globally, energy companies led all sectors this month, climbing 1.9 percent, followed by utilities and telecommunications, which both had a 1.6 percent gain, according to Bank of America Merrill Lynch index data.

Debt of auto companies trailed the most, advancing 0.7 percent, while financial services firms gained 1 percent.

Further Tightening

As companies take advantage of still buoyant investor demand and borrowing costs at almost unprecedented lows, issuance of corporate bonds worldwide reached $393 billion this month, the most in May since 2011, according to data compiled by Bloomberg. This year, global company sales are $1.86 trillion, ahead of $1.83 trillion sold in the same period in 2013 and $1.67 trillion in 2012, which ended as a record year, Bloomberg data show.

Spreads may tighten once Treasury yields stabilize, said Ashish Shah, head of global credit investment at New York-based asset management firm AllianceBernstein Holding LP.

A worldwide bond-market surge starting in January has pushed sovereign yields to the lowest levels in about a year on growing evidence central banks from the U.S. to the euro area, Japan and the U.K. can keep stimulating economic growth without igniting inflation.

The benchmark U.S. 10-year Treasury yield fell as low as 2.40 percent yesterday in New York, the least since June and down from 3.05 percent on Jan. 2.

Taking Pause

“It’s been a really long rally, and investors probably need to take a breather,” Shah said in a telephone interview. “When you get rapid moves lower in yield, typically spreads tend to lag. Investors need to get used to it, so they take a pause.”

Shah pointed to the 1990s, when spreads on the Bank of America Merrill Lynch U.S Corporate & High Yield Index hit 87 basis points in October 1997. Spreads may widen if M&A activity picks up, or if earnings start to disappoint, he said.

As growth slows, central bankers are seeking to spur expansion. U.S. gross domestic product fell at a 1 percent annualized rate in the first quarter, worse than the most pessimistic forecast in a Bloomberg survey of economists, revised Commerce Department figures showed yesterday in Washington.

Monetary Measures

The European Central Bank is considering a package of monetary measures to increase economic output in the region, including negative interest rates on deposits. The Bank of Japan is buying about 7 trillion yen ($68.8 billion) of sovereign bonds a month as the central bank battles deflation in the world’s third-biggest economy.

“The economy is in a confused state right now,” Larkin said. Investors may be waiting “until we get a little more economic data that indicates who’s right or who’s wrong.”

About 74 percent of S&P 500 Index (SPX) companies that reported quarterly earnings in the period Feb. 16 to May 15 surpassed estimates, up from 72 percent in the equivalent period last year, Bloomberg data show.

Corporate debt continues to outperform sovereign debt, with global returns averaging 5.1 percent this year compared with 3.7 percent, Bank of America Merrill Lynch index data show. Even so, fund managers are anxious.

“I remain cautious,” Matthew Duch, a fund manager at Calvert Investments in Bethesda, Maryland, which oversees more than $12 billion in assets, said in a telephone interview. “Eventually actions will come that are negative for credit bond holders.”

To contact the reporters on this story: Caroline Chen in New York at cchen509@bloomberg.net; Matt Robinson in New York at mrobinson55@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net John Parry

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