BofA Cools on Junk Priciest to Stocks Since ’93: Credit Markets

BofA Cools on Junk Priciest to Stocks Since ’93
Dunkin’ Brands Group Inc., the owner of the doughnut chain bearing its name, is seeking to borrow as much as $400 million more under its existing loan agreement. Photographer: Scott Eells/Bloomberg

Junk bonds are losing their sheen after becoming about the most expensive relative to stocks in at least two decades, prompting firms from Bank of America Corp. to Loomis Sayles & Co. to warn that gains on the debt may wane.

Speculative-grade bonds in the U.S. have underperformed investment-grade notes for the longest stretch since November. The securities yield 0.14 percentage point less than a similar measure for the Standard & Poor’s 500 index of stocks, data compiled by Bloomberg show. As recently as last month the bonds yielded about half a percentage point more than equities.

Bond-fund managers that in May preferred putting their money in junk debt have shifted back to favoring the safest corporate notes, Bank of America strategists said in a July 23 report. With prices 8 percent higher than the historical average, the bonds are losing value this week as Europe’s debt crisis deepens and U.S. consumer confidence reaches the lowest level in two months.

“If you invest in it at these levels, you have to go in with eyes wide open,” said Matthew Eagan, a Boston-based manager of the Loomis Sayles Absolute Strategies fund, which has outperformed 94 percent of its peers this year. “Your maximum upside is limited to basically earning your coupon. Your downside is, what if there’s a major risk-off trade?”

Junk Gains

Speculative-grade bonds gained 105 percent since the end of 2008 through July 20, Bank of America Merrill Lynch index data show. That compares with a 58 percent return for the S&P 500. With an International Association of Credit Portfolio Managers survey showing investors the most pessimistic about the outlook for junk bonds since 2008, the debt is poised to underperform investment-grade debentures this year, Bank of America strategists are forecasting.

“In the next month or so, with what’s happening in Europe, we’ll see some volatility,” said Adam Richmond, a high-yield bond strategist at Morgan Stanley. “If I were an investor, I’d be looking to add on weakness, but maybe not today.”

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined for a third day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 3.1 basis points to a mid-price of 108.2 basis points as of 12:02 p.m. in New York, according to prices compiled by Bloomberg.

Rate Swaps

The measure typically falls as investor confidence improves and rises as it deteriorates. 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 bond market stress, decreased 0.07 basis point to 21.18 basis points as of 11:58 a.m. in New York. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

Bonds of Bristol-Myers Squibb Co. are the most actively traded dollar-denominated corporate securities by dealers today, with 124 trades of $1 million or more as of 12:03 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The biopharmaceutical producer sold $2 billion of bonds yesterday.

Junk Inflows

Investors have put $41.6 billion into junk-bond funds in 2012 as the Fed holds its benchmark interest rate near zero for a fourth year and yields on 10-year U.S. Treasuries plummeted to a record low 1.38 percent on July 25. Fund inflows are up from $13.94 billion in the same period last year and a net $8.3 billion for all of 2011, according to EPFR Global data.

Helping to lure investors, the global speculative-grade corporate default rate of 2.7 percent at the end of the second quarter was almost half the historical average of 4.8 percent since 1983, according to Moody’s.

Demand for the debt has pushed yields on dollar-denominated speculative-grade notes to 7.7 percent, within half a percentage point of the record-low level reached in May 2011, Bank of America Merrill Lynch index data show.

“There’s a lot of risk out there that’s not reflected in current pricing” of high-yield bonds, said Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which oversees $40 billion. “How much juice can you squeeze out of a lemon? It’s pretty toppy here.”

Negative Outlook

The credit portfolio managers group’s gauge of investor sentiment in the junk-bond market dropped to negative 26.8 at the end of the second quarter, the lowest since September 2008, the association said this week. The survey of 84 financial institutions from Deutsche Bank AG to Barclays Plc, gauges sentiment about corporate credit, with negative levels indicating the expectation of deterioration of conditions.

The yield-to-worst on the debt, a measure that takes into account the risk that bonds will be redeemed early, was 7.1 percent on July 24, Barclays data show. That compares with a 7.37 percent so-called earnings yield for the S&P 500, which represents company earnings divided by the price of the index.

The ratio between the two measures, which is higher when the debt is viewed as more expensive, turned positive for the first time in February, according to the data.

‘Lurking’ Risks

“Most people like myself would look at the high-yield market and not give it a resounding endorsement for people to invest in right now,” Loomis Sayles’s Eagan said in a telephone interview. “I do think it could play a strategic role in a portfolio to build yield in a low-yield world. Just recognize there are exogenous risk factors lurking out there right now that could result in a bumpy ride from time to time.”

Consumer confidence in the U.S. fell last week to the lowest level in two months as Americans became more concerned employment growth will remain sluggish. The Bloomberg Consumer Comfort Index fell to minus 38.5 in the week ended July 22 from minus 37.9 in the previous period.

The IMF projects the euro-area economy will expand 0.7 percent in 2013, with economies in Italy and Spain contracting for a second consecutive year. That compares with an expected growth rate of 2.3 percent in the U.S. next year.

European Central Bank President Mario Draghi said yesterday that policy makers will do whatever is needed to preserve the euro, suggesting they may intervene in bond markets as surging yields in Spain and Italy threaten the existence of the 17-nation currency bloc.

‘Better Entry’

“The macro data has deteriorated, we do think the second half will be volatile,” said Morgan Stanley’s Richmond, who thinks speculative-grade debt is attractive as a medium-term investment. “You’ll probably find better entry points than today,” he said.

Junk bonds are returning less than the highest-rated corporate notes for the fourth straight week, the longest stretch since the period ended Nov. 27, Bloomberg data show. Investment-grade bonds in the U.S., which are lagging half a percentage point behind junk bonds for the year, will post superior returns in 2012, according to a July 9 Bank of America forecast.

The Charlotte, North Carolina-based firm is still overweight credit, including speculative-grade notes.

“You can think about investing in the stock market, but as the economy has slowed down so much it’s hard to see how the stock market can generate the returns that investors are looking for,” said Hans Mikkelsen, a credit strategist at Bank of America in New York, in a telephone interview.

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