Fed-Induced Rally Makes Riskiest Debt Priciest: Credit Markets
The lowest-rated junk bonds are the most expensive corporate debt following a Federal Reserve- induced rally in high-risk assets, adding to concern fixed- income securities are overvalued.
The extra yield investors demand to hold global bonds rated CCC or lower instead of government debt is about 10.1 percentage points, or 3.4 percentage points narrower than the average over the past 12 years, according to Bank of America Merrill Lynch index data. Debt with B ratings is the only other part of the market trading tighter than its historical average.
Record-low interest rates in the U.S. and Europe, and speculation the Fed will purchase more bonds to keep the economy from faltering, are encouraging debt investors to take on riskier securities and stoking concern prices are rising to unsustainable levels. Goldman Sachs Group Inc. advised its clients to avoid adding CCC rated debt in a report published Oct. 22 because of slower economic growth.
“With CCCs even more richly valued than historically, the risk of poor relative returns in the future would appear to be high,” said Martin Fridson, a global credit strategist in New York at BNP Paribas Asset Management, who began his career as a corporate debt trader in 1976. “You have to be conscious of that risk of underperformance. Having relatively rich valuations puts investors at a handicap.”
The rally in the lowest-rated company bonds has sparked a surge in issuance. MGM Resorts International, the biggest casino operator on the Las Vegas Strip, Energy Future Holdings Corp. and other companies have sold $6.5 billion of bonds this month rated CCC+ or lower by Standard & Poor’s or Caa1 or lower by Moody’s Investors Service, data compiled by Bloomberg show.
That’s the most since April for debt S&P deems “currently vulnerable to nonpayment” and “is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment.”
Elsewhere in credit markets, the extra yield investors demand to own company bonds instead of similar maturity government debt fell 1 basis point to 166 basis points, or 1.66 percentage point, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. That’s a decline of 7 basis points this month. Yields averaged 3.43 percent from 3.45 percent on Oct. 22.
Morgan Stanley, the sixth-largest U.S. bank by assets, plans a benchmark sale of notes, according to a person familiar with the offering. Benchmark issues are typically at least $500 million.
The five-year debt, set to be sold as soon as today, may yield about 230 basis points more than similar-maturity Treasuries, said the person, who declined to be identified because terms aren’t set.
Goldman Sachs plans to sell $1.3 billion of 50-year debt at a 6.125 percent yield as soon as today, according to a person familiar with the transaction. The offering may include bonds with a face value of $25 that can’t be called for five years, the person said.
The cost of protecting bonds from default in the U.S. held near the lowest level since May. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, increased 0.1 basis point to a mid-price of 93.5 basis points as of 12:21 p.m. in New York, according to index administrator Markit Group Ltd.
The index, which typically rises as investor confidence deteriorates and falls as it improves, ended May 3 at 90.5 basis points.
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, 0.01 percentage point, equals $1,000 annually on a contract protecting $10 million of debt.
Goldman Sachs said bonds rated CCC+ and lower by S&P or Caa1 by Moody’s were “expensive” given expectations for economic growth, and recommended clients buy higher-ranked company bonds instead. John Lipsky, the No. 2 official at the International Monetary Fund, said last month that global economic growth in the second half of the year will fall short of the fund’s forecast of 3.75 percent on an annualized basis.
“You don’t want to stand in the way of the search for yield,” said Alberto Gallo, a global credit strategist at Goldman Sachs in New York. “But on the other hand it is a very volatile part of the market. And it can be particularly sensitive to a further slowdown in the economy.”
Yields on U.S. investment-grade debt fell to a record low of 3.55 percent this month, the lowest borrowing cost on record in data going back to October 1986, according to Bank of America Merrill Lynch index data. For CCC bonds and lower, yields dropped to 11.63 percent yesterday, the lowest level since November 2007, the data show.
Average spreads on the lowest-rated debt have narrowed from as high as 1,183 basis points in June and a record 4,560 basis points in December 2008, according to Bank of America Merrill Lynch index data. Debt in the B range pays a spread of 602 basis points, or 31 basis points less than their average over the past 12 years. Investment-grade securities pay a premium of 8 basis points to 30 basis points over their longer-term averages.
Investors are paying ever-higher prices on speculation the money the Fed injects into the economy will allow the neediest borrowers to refinance the more than $815 billion of loans and bonds that Bank of America Merrill Lynch estimates comes due through 2015.
JPMorgan analysts predicted in a report this month that the high-yield default rate for bonds will fall to 1.4 percent next year, compared with the 6 percent implied by bond yields.
Of the junk-rated bonds sold in the U.S. this year, 16.2 percent are from issuers rated CCC by at least one ratings firm, up from 10.7 percent in 2009, according to JPMorgan. That’s still below the 25 percent average over the five years ended in 2008, the firm said in an Oct. 22 report.
MGM sold $500 million of six-year notes at a yield of 10.25 percent to repay lenders under its senior credit facility, Bloomberg data show. Covenant Review LLC, a debt research firm, said in a report that Las Vegas-based MGM is offering investment-grade type covenants even though the bonds will be junk-rated, including no restrictions on the company’s ability to incur debt, make dividends, or sell assets.
The offering, along with the sale of stock and certain assets, should address all of MGM’s bank debt maturities in 2011, according to KDP Investment Advisors Inc., a Montpelier, Vermont-based debt research firm.
Dallas-based Energy Future, known as TXU Corp. before KKR & Co. and TPG Capital paid $43.2 billion for the electricity provider in 2007, raised $350 million on Oct. 15 in an offering of second-lien notes due in April 2021 yielding 15 percent.
Securities rated CCC and lower have returned 16.8 percent this year, after gaining 101 percent in 2009. This year’s returns compare with 15.5 percent for debt ranked BB and 12.9 percent for B bonds. Debt rated BBB has gained 11.6 percent, the best among investment-grade bonds.
“We’re in a scenario where there is a desperate need for yield,” said Gary Jenkins, head of fixed-income at Evolution Securities Ltd. in London. “Corporates are almost seen as a quasi-safe haven. It won’t be the case if the economy turns negative, double dip-like.”
The lowest-rated bonds are “quite rich” by historical standards partly because hedge funds that rely on debt to boost returns have become bigger players in the market and don’t care as much whether the spread compensates for default risk, according to Fridson.
“I had thought the downturn would either blow away some of the leveraged players or at least induce them to tighten up their risk management,” he said. “That has not happened.”
Lack of Alternatives
Money managers are piling into the riskiest junk bonds and taking ever-lower yields and spreads because they face a lack of alternatives. Investments on everything from government debt to corporate bonds are paying some of the lowest coupons on record as the Fed holds its target overnight lending rate between banks in a range of zero percent to 0.25 percent since December 2008. The European Central Bank’s main refinancing rate has been at a record-low 1 percent since May 2009.
The Treasury sold $10 billion of five-year Treasury Inflation Protected Securities at a negative yield for the first time at a U.S. debt auction as investors bet the Fed will be successful in sparking inflation.
The securities drew a yield of negative 0.55 percent, the same as the average forecast in a Bloomberg News survey of 7 of the Fed’s 18 primary dealers. The sale was a reopening of an $11 billion offering in April.
“The low government yield environment is squeezing investors into riskier assets, which I suppose is partly what the Fed wants,” Jim Reid, head of fundamental strategy at Deutsche Bank in London, said in an Oct. 25 note to clients. “It remains a gamble though, as if it doesn’t feed into the economy it will eventually leave a bigger gap between asset prices and the fundamentals.”
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