Junk-Bond Buyers Plot Escape in Debt Gap: Credit Markets
Junk-bond buyers are giving up the most yield in seven months to own the biggest, most-easily traded securities as they increasingly hedge their bets that the three-month rally will continue while the global economy slows.
Investors are accepting 1.2 percentage points less in yield to own bonds from bigger, newer U.S. high-yield offerings that are more actively traded and easier to dispose of than older, smaller issues, according to Barclays Plc (BARC) data. The gap, which is benefiting larger junk issuers such as Sprint Nextel Corp. and Community Health Systems Inc., is the most since January and six times the 0.2 percentage-point average since August 2007.
High-yield fund managers investing a record $44.9 billion of deposits this year are selecting bonds they can sell more easily if investors start withdrawing the money. Even as the Standard & Poor’s 500 index returned 3.4 percent since the end of June, typically a benefit to the riskiest debt, the highest- rated junk bonds have outperformed the lowest-ranked by 0.4 percentage point, Bank of America Merrill Lynch index data show.
“Investors are right to be nervous about holding less- liquid paper,” said Michael Kessler, a Barclays credit strategist in New York, using market vernacular for bonds that are more difficult to sell when buyer appetites wane. “What’s different now is that it’s happening during a pretty significant rally.”
The Federal Reserve’s outlook that it will hold interest rates near zero through at least late 2014 has goaded investors to funnel cash toward riskier assets, even as Chairman Ben S. Bernanke warns Europe’s fiscal turmoil is creating “spillover effects” in the rest of the world. The average yield on speculative-grade bonds in the U.S. was 7.42 percent yesterday, 0.2 percentage point from the record-low 7.19 percent reached in May, Bank of America Merrill Lynch index data show.
The divergence between the most and least liquid bonds shows buyers are holding on to some caution after Wall Street’s biggest banks, responding to tougher capital rules that make trades costlier, retreated from their previous role of acting as buyers to buffer against plummeting prices.
While demand for higher-yielding bonds spurred a record July volume of new junk-debt sales, dealers traded an average 62 percent fewer bonds during the month compared to 2007 as they shrank their corporate debt holdings by 82 percent, data from the Fed show.
“As a trader, you have to be prepared to quickly adjust to market conditions,” said Arthur Tetyevsky, a credit strategist at Jefferies Group Inc. in New York. “You want to make sure you have enough liquid positions so as to allow yourself to get down risk when it’s required.”
Elsewhere in credit markets, Royal Dutch Shell Plc (RDSA) plans to raise funds with the first bond offering by Europe’s largest oil producer in two years. UniCredit SpA raised 750 million euros ($924 million) by selling the first covered bonds from an Italian borrower this year. The cost to protect against U.S. corporate defaults fell to the lowest since May 8.
A unit of Royal Dutch Shell plans to sell debt with five-, 10- and 30-year maturities. Shell International Finance, which last issued dollar obligations due in three decades in March 2010, will use proceeds for general corporate purposes, The Hague-based company said today in a regulatory filing.
The sale will be of benchmark size, typically at least $500 million, and the bonds may be rated Aa1 by Moody’s Investors Service, its second-highest grade, according to a person familiar with the offering who asked not to be identified because terms aren’t set.
UniCredit, Italy’s largest bank, sold the covered bonds due in 2018 to yield 290 basis points, according to a person with direct knowledge of the deal. That compares with a spread of 368 basis points that investors demanded to hold the Italian government’s 4.5 percent bonds with a similar maturity, according to data compiled by Bloomberg.
Covered bonds typically get higher ratings than unsecured debt because they’re backed by mortgages or public sector loans and guaranteed by the issuer.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, was little changed, falling 0.06 basis point to 19.94 basis points as of 11:06 a.m. in New York. The measure, which has declined from a four-month high of 39.13 on May 15, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
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, dropped 0.7 basis point to a mid-price of 102 basis points, according to prices compiled by Bloomberg.
The indexes typically fall as investor confidence improves and rise as it deteriorates. 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.
Bonds of New York-based JPMorgan Chase & Co. were the most actively traded dollar-denominated corporate securities by dealers today, with 83 trades of $1 million or more as of 11:25 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
The biggest U.S. bank by assets raised $2.5 billion yesterday selling five-year debt at its lowest fixed rate on record for the maturity.
The yield on U.S. speculative-grade bonds issued in lots of more than $500 million within the past 18 months was 6.12 percent on Aug. 7, Barclays data show. Bonds smaller than $250 million and offered more than 18 months ago yielded 7.31 percent, the data show.
“Investors continue to put a premium on liquidity, which helps to explain the demand for newly-priced bonds,” Jefferies’ Tetyevsky said.
The money investors have poured into funds that buy speculative-grade bonds this year is more than three times inflows from the same period last year as measured by Cambridge, Massachusetts-based EPFR Global. The investments have fueled a 4.6 percent gain in dollar-denominated junk bonds since May and returns of 9.7 percent this year, Bank of America Merrill Lynch index data show.
The divide is favoring some of the biggest issuers in the U.S. junk bond market.
Franklin, Tennessee-based hospital chain Community Health’s $1.6 billion of six-year notes sold Aug. 8, the third-most actively traded debt recorded by Trace the past 10 days, yielded 4.7 percent in trading yesterday. That compares with an average 5.7 percent yield on other bonds rated in the BB tier, Bank of America Merrill Lynch index data through Aug. 10 show.
Overland Park, Kansas-based Sprint Nextel’s $1.5 billion of eight-year bonds sold on Aug. 9, the sixth-most active during the same period, yielded 6.9 percent yesterday, compared with an average 7.36 percent for other B rated notes.
Buyers remain guarded as Bernanke said in a speech to teachers last week that the U.S. “economy is still in a fragile recovery” and the central bank works to lower the nation’s unemployment rate, which has held at 8 percent or higher for 42 straight months. U.S. forecasters cut their outlook for growth and see weaker labor market conditions, according to the Federal Reserve Bank of Philadelphia’s Third Quarter Survey of Professional Forecasters released on Aug. 10.
“People are definitely wary of a sudden leg down,” Barclays’s Kessler said. “People know lower-quality high yield needs economic growth.”
While the highest-rated junk bonds have gained 2.7 percent since the end of June, the lowest-rated notes, which usually outperform during a rally, returned 2.35 percent, Bank of America Merrill Lynch index data show.
The 21 primary dealers that trade directly with the Fed have cut their holdings of corporate securities due in more than a year to $41.7 billion as of Aug. 1 from a peak of $235 billion in October 2007, Fed data show. Their average weekly trading volumes in July were $95.5 billion, compared with $254.6 billion during the same period five years ago, according to the data.
“Dealers are pulling back inventory,” said Jason Rosiak, head of portfolio management at Pacific Asset Management, the Newport Beach, California-based affiliate of Pacific Life Insurance Co. “That’s affecting trading across the board. It’s a challenge for larger firms to rotate their portfolios to exit and enter positions. It’s more of an artful craft these days.”
When buyers decide to sell bonds, they can’t reliably get rid of $10 million or $20 million chunks by going to a dealer as they did before the credit crisis, said Brian Machan, a money manager with Aviva Investors North America in Des Moines, Iowa, who helps oversee $433 billion.
“There’s going to be a bigger difference between on-the- run and off-the-run bonds,” he said.
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