Junk Returns Seen Soaring as Europe Crisis Wanes: Credit Markets

Junk bond returns may triple from last year as confidence builds that Europe will avert a sovereign-debt crisis and investors turn their attention to a U.S. recovery, according to analyst forecasts.

JPMorgan Chase & Co. strategists led by Peter Acciavatti, the top-rated high-yield team in Institutional Investor magazine’s annual poll, raised their estimate last week for 2012 gains to 13.7 percent from 9.4 percent. While Bank of America Merrill Lynch expects returns of 12.3 percent, Barclays Capital is holding with 5 percent to 7 percent, saying Greece is still grappling with fiscal challenges.

High-yield, high-risk debt in the U.S. is rallying as Greece’s second bailout in three years helps avert a global credit crisis and the Standard & Poor’s 500 Index reaches an almost four-year high with the U.S. unemployment rate at the lowest since February 2009. Junk bonds have returned 1.21 percent this month, following a gain of 5.45 percent in December and January, the best back-to-back returns since September 2009.

“When people see that better U.S. economic data, and they see the stock market up, they feel it’s safe to go back into the water and a good time to go back into high yield,” said Marc Gross, a money manager at RS Investments in New York, who oversees $2.5 billion of high-yield debt in funds. “The market seems somewhat satiated that Greece isn’t going to be a disaster and it’s manageable for now, and that is decreasing the tail risk that JPMorgan was looking for.”

‘Brighter Macro Picture’

High-yield returns for 2012 would compare with a 4.4 percent gain last year, following 15.2 percent in 2010 and a record 57.5 percent in 2009, according to Bank of America Merrill Lynch index data.

“When we set our 2012 targets for high yield back in December, concern of a systemic crisis in Europe and U.S. recession were widespread,” JPMorgan strategists led by Acciavatti said in the Feb. 17 note. “The brighter macro picture augurs the case for the rally in high yield extending and the low yield environment being sustained.”

Elsewhere in credit markets, a benchmark gauge of U.S. company debt risk rose, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 1.2 basis points to a mid price of 98.7 basis points as of 12:13 p.m. in New York, according to data provider CMA.

Bondholder Protection

The index 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.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.24 basis point to 29.69 basis points as of 12:20 p.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Bonds of BHP Billiton Ltd. were the most actively traded U.S. corporate securities by dealers today, with 217 trades of $1 million or more as of 12:22 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The world’s biggest mining company sold $5.25 billion of bonds yesterday.

Mutual Fund Inflows

The junk rally is being propelled by the lowest-ranked debt, with bonds graded CCC or lower gaining 6.67 percent since year-end, Bank of America Merrill Lynch index data show. Overall, high-yield bonds have returned 4.15 percent while investment grade gained 1.99 percent. The December and January gains are the most since an 8.13 percent return in the two months ended September 2009.

High-yield, or junk-rated, bonds are graded below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.

Even as investors pour $12.6 billion into high-yield mutual funds this year, a record pace, the securities remain relatively attractive compared with stocks, government debt and investment-grade corporate bonds, the JPMorgan strategists said in the research note.

The S&P 500 rose above its highest close since 2008 yesterday, while investment-grade debt yields 3.55 percent and 10-year Treasuries offer about 2 percent.

The JPMorgan strategists estimate a yield of 7 percent at the end of the year and a spread of 570 basis points, according to the report. The strategists also raised their return forecast for loans to 8.8 percent from 7 percent.

Yields on high-yield debt were 7.7 percent, Bank of America Merrill Lynch index data show.

Jobless Rate Falls

“I thought that the return they had at the beginning of the year was way low,” Gross said of the JPMorgan forecast.

“Fundamentally, the U.S. economy is getting better.”

A report last week showed the Federal Reserve Bank of Philadelphia’s general economic index increasing to 10.2, topping the median economist forecast for a reading of 9. Housing starts climbed 1.5 percent to a 699,000 annual rate in January, the Commerce Department said. The U.S. jobless rate fell to 8.3 percent last month.

Greece won 130 billion euros ($172 billion) in aid it needs to avoid a March bankruptcy this week after seven months of negotiations. The nation signed up to a program of austerity and economic reform aimed at slashing debt to 120.5 percent of gross domestic product by 2020 from about 160 percent last year.

Bradley Rogoff, who leads the No. 2 high-yield team at Barclays Capital according to the Institutional Investor magazine poll, said it’s too early to change forecasts for the year, especially after gains for 2011 were wiped out in October.

‘Fully Priced In’

“A good outcome in Greece is fully priced in,” said Rogoff, the head of U.S. credit strategy in New York. “It looks like we’re more likely to avoid a worst-case scenario, but any hiccups in Greece will certainly lead to some kind of selloff. We’re priced for perfection for a lot of the high-yield market.”

The 6.3 percent return in the first seven months of last year turned into a loss of 1.7 percent by the end of September as the European sovereign debt crisis roiled markets, Bank of America Merrill Lynch index data show. The securities rallied 6.2 percent in the fourth quarter.

“Our forecast of 5 to 7 percent doesn’t imply some hugely negative outcome” Rogoff said. “It does imply some lower prices on bonds than where they are today. That’s taking into account a lot of macro risks that aren’t fully priced into the market today. Fundamentals are still solid but they’re not strengthening to the same effect as last year.”

Taking the Risk

Bank of America Merrill Lynch strategists led by Oleg Melentyev in New York anticipate spreads tightening to 550 basis points by the end of the year, while five-year Treasury yields rise by 50 basis points, according to a Dec. 15 report. The bank is ranked No. 3 in the magazine poll.

Relative yields on junk bonds have fallen to 614 basis points, the lowest since Aug. 3, and down from last year’s high of 910 on Oct. 4 as debt swaps signaled a near-certain probability of Greece defaulting.

“Investors are hungry for yield and confident enough in the economic outlook to be willing to take the risk,” Martin Fridson, global credit strategist at BNP Paribas Investment Partners, said in a telephone interview from New York. “That projection of 13 percent would be a great outcome if it turns out that way but it is dependent on considerable further spread tightening.”

“The biggest concern investors would have is about a relapse into recession and that concern has been going down steadily,” Fridson said.

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