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UBS Stargazing Signals Back-to-Back Bond Losses: Credit Markets

Fed Reserve Vice Chairman Janet Yellen
Janet Yellen, vice chairman of the U.S. Federal Reserve and U.S. President Barack Obama's nominee as chairman of the Federal Reserve, listens during a Senate Banking Committee confirmation hearing in Washington, D.C. on Nov. 14, 2013. Photographer: Andrew Harrer/Bloomberg

Nov. 15 (Bloomberg) -- Wall Street is starting to signal that 2014 will look a lot like 2013 for U.S. corporate bond investors, setting the stage for the first back-to-back annual losses for investment-grade securities on record.

The debt, on pace to lose 1.9 percent this year as investors reject record low yields in favor of stocks, will drop an additional 0.9 percent in 2014, UBS AG analysts led by Matthew Mish said this week. That followed Citigroup Inc.’s forecast last month for a 1.1 percent decline through next year.

An unwinding of the Federal Reserve’s unprecedented stimulus as the economy improves is threatening future gains for investors who have reaped average annual returns of 11.7 percent from the start of 2009 through last year on the Bank of America Merrill Lynch U.S. Corporate Index. Even as Treasuries rallied yesterday with Janet Yellen committing to further bond buying, the nominee for Fed chairman said the program won’t continue indefinitely.

“This is a coupon-clipping asset class, and because you’re starting from a low yield, there’s not a lot of cushion” against a rise in benchmark rates, Mish said yesterday in a telephone interview from New York. “We’re heavily dependent on the interest-rate outlook, for better or worse, which is going to be driven by the Fed and other central banks.”

‘Challenging Year’

Dollar-denominated speculative-grade bonds will return 2.1 percent next year, the UBS analysts wrote, less than a third of the annualized 7 percent this year through yesterday on the Bank of America Merrill Lynch U.S. High Yield Index.

Leveraged loans are a bright spot in what UBS is expecting will be a “challenging year” as demand grows for floating-rate securities that can help guard against the effects of rising rates, the analysts wrote in a Nov. 13 report. Loans in the U.S. may return 6.5 percent, according to the report, compared with an annualized 5.16 percent in 2013 on the Standard & Poor’s/LSTA Leveraged Loan Total Returns Index.

“You won’t have the negative implications of rising rates hit that asset class,” said Mish of UBS, Switzerland’s largest bank. “Many of the higher-quality, lower-yielding asset classes are just not attractive on an outright basis.”

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. fell, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 0.6 basis point to a mid-price of 71 basis points as of 10:27 a.m. in New York, according to prices compiled by Bloomberg.

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 debt market stress, rose from the lowest level in a year, climbing 0.3 basis point to 10.81 basis points. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.

Bonds of Wells Fargo & Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.8 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Lehman Failure

Dollar-denominated investment-grade bonds have never failed to deliver positive total returns for two consecutive years in Bank of America Merrill Lynch index data that dates back to 1974.

The biggest decline on record on the Bank of America Merrill Lynch U.S. Corporate Index was a 6.8 percent drop in 2008, when the failure of Lehman Brothers Holdings Inc. caused a seizure across global credit markets.

The extra yield investors demand to hold dollar-denominated investment-grade debt rather than government debentures was 139 basis points as of yesterday, down from this year’s high of 165 basis points on June 25 on the Bloomberg U.S. Corporate Bond Index.

While investors are demanding less relative yield to own the debt, the contraction hasn’t made up for a surge in benchmark rates. The risk that corporate borrowing costs will rise along with climbing Treasury yields will continue to threaten the company debt’s performance, according to Thomas Chow of Delaware Investments.

Citigroup Forecast

The yield on 10-year Treasuries has jumped almost 1 percentage point this year to 2.71 percent today as investors wager on when the Fed will begin to curtail $85 billion in monthly purchases of mortgage bonds and Treasuries.

Yields on the Bloomberg investment-grade bond index have climbed to 3.17 percent from a record-low 2.54 percent in May.

“Any positives that we get from spread compression due to positive fundamentals of the credits themselves, as well as strong technical demand, can be more than offset by interest-rate moves,” Chow, who helps oversee about $135 billion from Philadelphia, said in a telephone interview.

Citigroup forecasted a 0.7 percent decline for junk bonds through 2014, along with its estimate for losses on investment grade, according to an Oct. 24 report edited by Jeremy Hale, the New York-based bank’s head of macro strategy.

‘High Risk’

The third-largest underwriter this year of U.S. corporates projected an 11.2 percent return for the S&P 500 stock index, which has already gained 28 percent this year including reinvested dividends.

“A lot of people are concerned about rising rates,” said Marc Gross, a New York-based money manager at RS Investments. “That’s why leveraged loans and floating-rate notes are so favored and that’s why people are rotating into equities.”

Economists predict policy makers will pare the monthly pace of bond buying to $70 billion at their March 18-19 meeting, according to the median of 32 economist estimates in a Bloomberg News survey on Nov. 8.

Yellen, who is seeking to replace current Fed Chairman Ben S. Bernanke after his term ends Jan. 31, told the Senate Banking Committee yesterday that the benefits of the bond-buying program still outweigh the costs.

“There’s a high risk” for bond investors, said William Larkin, a portfolio manager at Cabot Money Management in Salem, Massachusetts. “The longer they go, the greater chance they cause an accident, and you don’t want to be sitting in long-term bonds or medium-term bonds when that happens.”

To contact the reporter on this story: Charles Mead in New York at

To contact the editor responsible for this story: Alan Goldstein at

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