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Housing Collapse Erased in Bonds of Homebuilders: Credit Markets

Housing Collapse Erased in Bonds of Homebuilders
Townhomes under construction at the Toll Brothers Inc. Bowes Creek Country Club development in Elgin, Illinois. Photographer: Daniel Acker/Bloomberg

Another bubble may be forming in the U.S. housing market, this time in the bonds of homebuilders.

Not since July 2007, before the subprime mortgage market collapsed and credit markets froze, have investors accepted relative yields as low as they are now for debt of the nation’s biggest homebuilders. So-called spreads at 4.82 percentage points on debt of borrowers from D.R. Horton Inc., the largest U.S. homebuilder by volume, to Toll Brothers Inc. have tightened nine times faster than the overall high-yield market since February, Bank of America Merrill Lynch index show.

While recent signs show a housing rebound, new home sales remain 73 percent below the 2005 peak with unemployment stuck above 8 percent for a 42nd straight month. The economic recovery will continue at a “modest” pace with real GDP growth at an annual rate of 2.25 percent in the second half of this year, the Congressional Budget Office said yesterday.

“The market is pricing in a spectacular recovery, quickly, and I don’t see that in the cards,” Vicki Bryan, an analyst at research firm Gimme Credit LLC, said in a telephone interview from New York. “There’s limited, if any, upside from here, even if investors are right.”

Debt of homebuilders has returned 17.4 percent this year, following a loss of 0.34 percent in 2011, according to the Bank of America Merrill Lynch U.S. High Yield, Homebuilders/Real Estate index. That compares with a return of 10.1 percent for the bank’s broader U.S. High Yield Master II index, after a 4.38 percent gain last year.

Limited Room

“I don’t see a lot of room to rally,” Sabur Moini, who manages about $2.5 billion of high-yield assets at Los Angeles-based Payden & Rygel, said in a telephone interview. “It’s tough to see how much tighter it could get. You’re pretty much capped.”

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. rose the most in three weeks, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 1.9 basis points to a mid-price of 101.4 basis points as of 11:08 a.m. in New York, according to prices compiled by Bloomberg.

Swap Spreads

That’s the biggest increase on an intra-day basis since Aug. 2 for the measure, which 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, decreased 1.78 basis points to 17.44 basis points as of 11:07 a.m. in New York. That’s the lowest on an intra-day basis since May 30, 2011, for the gauge, which narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Bonds of Caracas-based Petroleos de Venezuela SA, or PDVSA, are the most actively traded dollar-denominated corporate securities by dealers today, with 45 trades of $1 million or more as of 11:11 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Credit Freeze

The last time relative yields were this low on homebuilder bonds was in July 2007, two weeks before BNP Paribas SA marked the start of the worst financial crisis since the Great Depression by halting withdrawals from three investment funds that owned subprime mortgage securities. Spreads reached 478 basis points on Aug. 21 before rising to 482 yesterday, Bank of America Merrill Lynch index data show.

Homebuilders, along with lenders, real-estate firms and investment banks that bundled into securities the mortgages made to the least creditworthy borrowers, contributed to a run-up in housing prices that peaked in July 2006. Prices plummeted 35 percent from then until the market low in February, according to the S&P/Case-Shiller index.

Relative yields, which reached a record 2,534 basis points on Dec. 4, 2008, have tightened by 123 basis points since Feb. 28, the last time the spread exceeded the broader high-yield market, Bank of America Merrill Lynch index data show. That compares with a 13 basis-point decline since the end of February on the U.S. High Yield Master II index to 588.

‘Too Far’

“It’s gone too far too fast and that you’re not currently being compensated for the balance-sheet leverage in the sector,” said Jennifer Machan, a senior high-yield analyst in Des Moines, Iowa, at Principal Global Investors.

Speculative-grade U.S. homebuilders have an average debt to earnings before interest, taxes, depreciation and amortization, or EBITDA, of 9.78 times versus 3.64 for all U.S. junk-rated companies, Bloomberg-compiled data show.

Fort Worth, Texas-based DR Horton’s $350 million of 4.75 percent notes issued in April and due in May 2017, rated three levels below investment grade by S&P at BB-, traded yesterday at 105.9 cents on the dollar to yield 3.39 percent, Trace data show. That compares with an average yield of 3.35 percent on a Bank of America Merrill Lynch index of BBB rated debt maturing in five to seven years.

‘Better Value’

“That’s an investment-grade kind of yield, that’s spectacular credit quality,” Gimme Credit’s Bryan said. “There’s better value in many more sectors than the homebuilding sector.”

Jessica Hansen, a spokeswoman for DR Horton, didn’t immediately respond to a telephone call to her office and an e-mail seeking comment.

Concern that the potential for a greater homebuilder rally is limited comes as U.S. economic growth is forecasted by 78 economists surveyed by Bloomberg to slow to 2.1 percent in 2013 from 2.15 percent this year.

The U.S. will probably tip into recession next year if lawmakers can’t break an impasse over the federal budget, according to the nonpartisan Congressional Budget Office’s report. Economic output would shrink next year by 0.5 percent, joblessness would climb to about 9 percent with “economic conditions in 2013 that will probably be considered a recession,” the agency said in its biannual report on the budget and economic outlook.

Toll Brothers

While sales of new homes, counted when contracts are signed, rose 3.6 percent in July to a 372,000 annual pace, matching a two-year high, the figure compares with a peak of 1.39 million sales in July 2005.

“Fundamentals continue to improve in the sector, but that’s already reflected in the prices of the securities,” Thomas O’Reilly, who co-manages the $3 billion Neuberger Berman High Income Bond Fund in Chicago, said. “The gains there are going to be more market-related than outperforming the market.”

Toll Brothers reported fiscal third-quarter net income of $61.6 million yesterday on increased revenue, beating analysts’ estimates for the Horsham, Pennsylvania-based company, the largest U.S. luxury-home builder.

“The growth is beginning,” Douglas Yearley, chief executive officer of Toll Brothers, said in a Bloomberg Television interview. “There is a long way to go.”

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