House of Morgan Divided on Junk as Returns Wane: Credit Markets

JPMorgan Chase & Co. recommends sticking with U.S. high-yield bonds next year as the best protection against rising interest rates. Morgan Stanley cautions that valuations are unattractive following a record five-year rally.

Speculative-grade debt will return 5 percent in 2014 with default rates remaining below historic averages, according to analysts at JPMorgan, the largest underwriter of the notes since

2010. Investors need to lower their expectations and will see gains of 2.8 percent, Morgan Stanley said yesterday.

Wall Street is diverging on how much life is left for bonds that soared 119 percent in the four years from the depths of the credit crisis through last December. This year’s 5.8 percent gain on a Bloomberg high-yield index has been tempered by mounting concern over how quickly the Federal Reserve will curtail unprecedented stimulus that’s bolstered credit markets.

“High yield simply fares better” in a rising interest-rate environment, said Peter Acciavatti, whose team at New York-based JPMorgan is top-ranked for speculative-grade strategy by Institutional Investor magazine. “It’s a better place for investors to invest in.”

March Paring

Yields on the Bloomberg USD High Yield Corporate Bond Index soared to a one-year high of 7.02 percent in June from a record low 4.66 percent in May as investors anticipated the central bank was poised to cut the pace of its bond buying if the economy showed sustained improvement. The index lost 3.1 percent in June, the most since August 2011.

After Fed Chairman Ben S. Bernanke surprised markets in September by maintaining the pace of $85 billion of monthly purchases of mortgage bonds and Treasuries, yields on the Bloomberg index fell to 5.89 percent as of yesterday. 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 estimates in a Bloomberg News survey on Nov. 8.

Prices for junk debt of 103.4 cents on the dollar compare with an average since 2003 on the Bank of America Merrill Lynch U.S. High Yield Index of 96.2 cents. Speculative-grade debt is ranked below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.

‘Robust’ Market

“We aren’t arguing investors avoid high yield,” Adam Richmond, Morgan Stanley’s head of U.S. leveraged finance strategy, said in a telephone interview from New York. “We’re arguing that absolute returns are going to be low by historical standards.”

With the Fed stoking an appetite for riskier assets by holding its benchmark interest rate at between zero and 0.25 percent since December 2008, high-yield debt returned an average annualized 21.6 percent from the end of that year through 2012, Bank of America Merrill Lynch index data show.

Dollar-denominated investment-grade debt has lost 1.5 percent this year on the Bloomberg USD Corporate Bond Index, after gaining an average 8.9 percent in the previous two years.

Corporate treasurers will find a “robust” market for new high-yield issuance even as sales are expected to slow to about $300 billion next year, according to JPMorgan. The bank is estimating about $371 billion of issuance this year.

Borrowing costs at close to record lows have sent the default rate for U.S. speculative-grade debt to 2.5 percent in October from 3.6 percent a year earlier, Moody’s said Nov. 11.

‘Challenging Situation’

“It’s hard to get the market to back up substantially when default rates are as low as they are.” Acciavatti, the head of high-yield research at JPMorgan, said yesterday in a telephone interview. His team predicted a 2013 return of about 7.5 percent, compared with a 6.9 percent rise on the Bank of America Merrill Lynch high-yield index.

Morgan Stanley was the most bearish of Wall Street banks last year, predicting a 3.1 percent rise.

“It’s a challenging situation because we’re looking at improving growth, low defaults and rates likely rising,” Morgan Stanley’s Richmond said. “It’s not a terrible environment for high yield, but the issue really is the math.”

The banking empire that J. Pierpont Morgan built, known as the House of Morgan, was split in 1935 with the creation of Morgan Stanley, two years after Congress passed the Glass-Steagall Act to separate commercial and investment banks amid the Great Depression.

Bank of America Corp., the second-largest underwriter of the securities, expects a 4 percent to 5 percent return because of the risk of higher interest rates, according to a Nov. 26 report from analysts including Michael Contopoulos in New York.

Default Swaps

He said the debt won’t be able to absorb higher rates. The gap in yield between the securities and government debt has shrunk by 112 basis points since year-end to 422 basis points as of yesterday, according to Bank of America Merrill Lynch index data. Spreads reached this year’s high of 534 basis points in June.

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North American Investment Grade Index, used to hedge against losses or to speculate on creditworthiness, increased 0.2 basis point to a mid-price of 70.6 basis points as of 10:45 a.m. in New York, according to prices compiled by Bloomberg.

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.

Goldman Sachs

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, rose 0.12 basis point to 9.5 basis points. The gauge typically widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.

Bonds of Goldman Sachs Group Inc. are the most actively traded dollar-denominated corporate securities by dealers, accounting for 3 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.

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