U.S. Bond-Swap Divide Evaporates in Stress Sign: Credit Markets

U.S. Bond-Swap Divide Evaporates in Stress Sign
Elsewhere in credit markets, Ford Motor Co. sold $750 million of 3.5-year bonds in its second benchmark issue since regaining investment-grade ratings. Photographer: David Paul Morris/Bloomberg

The gap between corporate bond yields in the U.S. and credit-default swaps is vanishing amid speculation the securities are too expensive following the biggest monthly rally since October and a slowing economy.

Relative yields fell this week to within 10 basis points of the corresponding cost of default insurance, from 275 basis points in 2008, according to JPMorgan Chase & Co. In Europe, swaps exceed bond rates by 43 basis points.

Investors seeking a haven from a slowing global economy and deepening turmoil in Europe are putting their money in U.S. company bonds, pushing returns last month to 2.49 percent through July 30, Bank of America Merrill Lynch index data show. The gains came even as the International Monetary Fund cut its global forecast and the Federal Reserve sees growth of less than 2 percent with unemployment above 8 percent.

“It’s an indication people are concerned about recession,” Michael Hampden-Turner, a strategist at Citigroup Inc. in London, said in reference to the rising cost of default insurance over relative yields on the bonds. “It’s usually an indication of stress.”

The amount of credit-default swaps outstanding on an index tied to U.S. investment-grade debentures has risen to cover a net $80.3 billion of debt, up from $77.3 billion at the end of June, according to the Depository Trust & Clearing Corp.

Briefly Inverted

The gap between bonds and swaps last approached zero in May and inverted briefly last year. In Europe, the divergence has grown amid concern a breakup of the single currency would cause economic shocks and as a shortage of corporate bonds combined with excess liquidity from central banks drove down yields.

“There’s demand for bonds given the fact it’s right now seen as the safe-haven universe,” said Jochen Felsenheimer, managing director in Munich at Assenagon Credit Management, which oversees 1.85 billion euros ($2.3 billion).

Elsewhere in credit markets, corporate bond sales globally reached $293.5 billion last month for the busiest July on record. Level 3 Communications Inc., the broadband provider that bought Global Crossing Ltd. last year, is selling $400 million of eight-year bonds to refinance debt. A gauge of U.S. corporate credit risk fell.

Credit Benchmark

The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 1.6 basis points to a mid-price of 105.9 basis points as of 11:47 a.m. in New York, according to prices compiled by Bloomberg. The index fell 4.8 basis points in July after an 11 basis-point drop the previous month.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings fell 4.1 to 155.7. The index dropped 6.1 in July.

The indexes typically rise as investor confidence deteriorates and fall as it improves. 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 stress in bond markets, rose for a second day, widening 0.16 basis point to 20.25 basis points. The gauge, which dropped 4.4 basis points in July for the second straight monthly decline, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Citigroup Bonds

Bonds of Citigroup Inc. were the most actively traded dollar-denominated corporate securities by dealers today, with 112 trades of $1 million or more as of 11:50 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The third-biggest U.S. lender sold $1.25 billion of three-year notes yesterday in its first dollar-denominated benchmark offering in five months.

Offerings by companies from the U.S. to Europe and Asia surpassed the previous record of $286.4 billion set in July 2009, according to data compiled by Bloomberg. Yields on the Bank of America Merrill Lynch Global Broad Market Corporate index dropped to 2.998 percent yesterday from 3.014 percent on July 30.

Sales in July compare with $264.1 billion in June and a monthly average in the first six months of this year of $328 billion, Bloomberg data show. Yields on global investment-grade bonds have declined from 3.981 percent at year-end and 3.643 percent on July 31, 2011, Bank of America Merrill Lynch index data show.

Level 3

The Level 3 bonds, which may be sold as soon as today, will be used to a redeem a portion of its $700 million of 8.75 percent notes due in February 2017, according to a person familiar with the transaction, who asked not to be identified because terms aren’t set.

Level 3’s 2017 notes, which are callable in September, traded yesterday at 104.4 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The company last tapped the bond market on July 18, issuing $300 million of 8.875 percent, seven-year notes yielding 7.4 percentage points more than similar-maturity Treasuries, according to data compiled by Bloomberg.

Cash Deluge

The discrepancy between bonds and default swaps indicates a different kind of stress than that triggered by the collapse of Lehman Brothers Holdings Inc. in 2008, when investors dumped bonds, driving yields above the cost of insurance.

Now, the crisis in Europe, high unemployment rates and stalling growth in the U.S. as well as a slowdown in China, are prompting central banks to unleash an unprecedented flood of cheap cash, driving down sovereign debt yields as banks seek havens for the money. Yields on 10-year Treasuries are at about 1.5 percent and comparable German bunds offer 1.35 percent.

That’s boosting the attraction of corporate bonds. The extra yield investors demand to hold notes of all ratings globally decreased 18 basis points last month to 2.8 percentage points through July 30, the lowest level since May 8, Bank of America Merrill Lynch index data show. Spreads have tightened from 3.51 percentage points at year-end.

“The financial crisis was about solvency and liquidity,” said Tim Gately, head of European credit trading at Citigroup in London. “It’s not about liquidity this time around. There’s more liquidity than the market has ever seen.”

‘Spillover Effects’

The Fed’s balance sheet assets have grown to $2.85 trillion from less than $1 trillion in 2008, while European Central Bank President Mario Draghi has cut the ECB’s benchmark interest rate twice, to 1 percent, and expanded its balance sheet to more than 3 trillion euros since assuming office Nov. 1.

“Managers continue to get cash in and there’s nowhere else to go with the money,” Gately said. “CDS are much more driven by hedging and accounts trading the market momentum.”

The IMF cut its 2013 global growth forecast to 3.9 percent from the 4.1 percent estimate in April, and Fed Chairman Ben S. Bernanke warned that Europe’s financial woes are creating “spillover effects” in the rest of the world.

The prospect of distortion in U.S. credit markets is indicated by the gap between default swaps and JPMorgan’s measure of yields linked to about 1,000 securities of more than 200 American companies. Yields are based on the so-called the z-spread, which is the extra yield investors demand to hold bonds over the bank swap rate.

Safeway, Dell

Yields on investment-grade bonds in the U.S. fell to a record low 3.037 percent on July 30, according to the Bank of America Merrill Lynch U.S. Corporate Master index.

Swaps on Safeway Inc., the second-largest U.S. grocer, exceed the z-spread on bonds due in 2021 by a record 140 basis points. Dell Inc., the Round Rock, Texas-based computer maker, has a positive basis of 49 basis points, while the gap on electronics chain Best Buy Co. is at 385 basis points.

The basis is so positive for some companies “that it’s much more efficient” to bet against the cash bond market, Gately said. Analysts at Morgan Stanley and JPMorgan also recommend selling bonds and selling default swaps or using so-called credit-linked notes to profit from the gap.

The discrepancy in Europe is too high and should shrink whether the crisis worsens or improves because investors would remove hedges in a rally, while bonds would be caught up in a selloff, according to Saul Doctor, a credit strategist at JPMorgan in London.

“Though investors may be bearish, they do not want to sell cash bonds unless really forced to, due to the worry that they would find it difficult to buy them back at a later date and could possibly miss out on any rally,” Doctor said. “Instead, investors are hedging themselves by buying CDS protection.”

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