Vanguard to JPMorgan Dodging Neediest Borrowers: Credit Markets
Investors from Vanguard Group Inc. to JPMorgan Chase & Co. are shunning bonds from the neediest borrowers as a slowing economy sends the default rate for companies that ratings firms deem to be in “poor standing” to the highest level since 2009.
Vanguard’s $18.4 billion fund that buys junk bonds is “incrementally taking down risk on a credit-by-credit basis,” said Dan Newhall, principal at the biggest U.S. mutual-fund firm. J.P. Morgan Asset Management has been reducing debt from companies more affected by lower consumer spending and has “dramatically” decreased holdings of securities ranked CCC since 2009, said Bill Morgan, a high-yield fund manager.
Waning demand signals turbulence in the $173 billion bottom-tier of the junk market, where Standard & Poor’s says the default rate of borrowers from Energy Future Holdings Corp. to Caesars Entertainment Corp. (CZR) reached 27.2 percent in August, up 10 percentage points from a year earlier. Returns are slowing even as prices hover at about 14-month highs, Bank of America Merrill Lynch index data show.
“There’s not a whole lot of upside at these average prices,” said Newhall, who spoke on behalf of Wellington Management Co., which manages the Vanguard fund on a daily basis. “Demand from funds and institutional buyers is far outstripping the net high-yield new supply, and that’s leading people to bid up the prices.”
With sales of high-yield bonds proceeding at a record pace, borrowers graded B and lower sold the greatest proportion of new junk debt in September in 12 months, accounting for 37.7 percent of the month’s issuance, S&P data show.
Obligations in the bottom ratings tier are “judged to be of poor standing and are subject to very high credit risk,” according to Moody’s Investors Service.
Even as bond investors accept looser terms from speculative-grade companies, S&P has tallied 61 defaults this year, compared with 34 in the same period of 2011, the ratings firm said yesterday.
“Given where valuations are, investors have to be much more careful,” said Andrew Jessop, a high-yield fund manager at Pacific Investment Management Co., which oversees the world’s biggest bond fund. “In the CCC sector, you have to be quite cautious with the companies you’re buying.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreased 0.7 basis point to a mid-price of 96.6 basis points as of 11:17 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, fell 1.44 basis point to 10.81 basis points as of 11:16 a.m. in New York. That’s the lowest level on an intra-day basis since March 2010 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 JPMorgan are the most actively traded dollar- denominated corporate securities by dealers today, with 51 trades of $1 million or more as of 11:22 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 reported record third-quarter profit today that beat analysts’ estimates as mortgage revenue soared 72 percent.
The world economy will grow 3.3 percent this year, the slowest since the 2009 recession, and 3.6 percent next year, the International Monetary Fund said Oct. 9, compared with July predictions of 3.5 percent in 2012 and 3.9 percent in 2013. The Washington-based lender now sees “alarmingly high” risks of a steeper slowdown, with a one-in-six chance of growth slipping below 2 percent.
Third-quarter profits and sales for companies in the S&P 500 (SPX) probably fell in unison for the first time in three years, according to analysts’ estimates compiled by Bloomberg. Per- share earnings may have dropped 1.7 percent on average after they were little changed in the second quarter. Sales may have slipped 0.6 percent, the data show.
Returns of 0.48 percent this month on the lowest tier of junk bonds bring gains to 16.7 percent for 2012 on the Bank of America Merrill Lynch U.S. High Yield, CCC and Lower Rated index. That compares with 15.9 percent this year on the S&P 500 index and 12.7 percent for all junk bonds. The debt returned 1.58 percent in the corresponding period of September.
While the fundamental credit quality of high-yield notes remains strong in general, “demand from funds and institutional buyers is far outstripping the net high-yield new supply,” said Newhall, the head of oversight and manager search at Vanguard.
Michael Hong, the Vanguard High-Yield Corporate Fund (VWEHX) manager, “is concerned about the high prices of some of these bonds that people are willing to pay today,” Newhall said.
The average price on the lowest-rated bonds has risen to 91.97 cents on the dollar from 83.36 cents at the end of 2011, Bank of America Merrill Lynch index data show. Prices reached 92.86 cents on Sept. 19, the highest level since August 2011.
Investors funneled a record $33.8 billion into U.S. funds that buy speculative-grade notes, JPMorgan said in a Sept. 28 report. The funds reported $1.2 billion of outflows in the following two weeks, the data show.
Sales in the U.S. of junk bonds, rated below Baa3 by Moody’s and lower than BBB- at S&P, are proceeding at an unprecedented pace, with issuance of $262.7 billion exceeding the $210.6 billion sold in the corresponding period of 2010, the busiest year on record, according to data compiled by Bloomberg.
A Moody’s measure of weakness in bondholder protections included in U.S. junk-rated debt increased to 3.94 in September, the worst since November. The gauge, known as a covenant-quality score, compares with 3.71 in August and a 2012 average of 3.72 through last week, according to Moody’s.
In the past month, offerings of so-called payment-in-kind notes accounted for $2.6 billion of the $6.5 billion of deals this year, Bloomberg data show. PIK toggle bonds allow borrowers to elect to pay interest in cash or through issuing more debt, or a combination of the options, generally within the first few years of the bond’s term, according to Moody’s.
“There are components of the market that we tend to shun,” including PIK bonds and note sales used to pay dividends, JPMorgan’s Morgan said in a telephone interview from Cincinnati. “It’s just recently that we’ve started to see some degradation in the underwriting cycle.”
When relative yields contract enough, JPMorgan tends to sell riskier holdings, which may carry the lowest ratings or be from companies that managers view as most vulnerable, Morgan said. Spreads on junk bonds reached 557 basis points yesterday, down from this year’s high of 723 on June 5, Bank of America Merrill Lynch index data show.
The firm has recently taken money out of cyclical companies and increased debt from borrowers that are less susceptible to consumers’ willingness to spend money on discretionary items. JPMorgan Asset Management’s junk-bond portfolio has a lower proportion of debt with CCC and BB ratings versus comparable indexes and a higher proportion of B rated notes, Morgan said.
The 12-month-trailing default rate on the lowest-rated speculative-grade companies compares with 17.2 percent in August 2011 and is the highest since reaching 54 percent in November 2009, S&P data show.
The $16 billion of CCC tier notes from Dallas-based Energy Future, the electricity producer formerly known as TXU Corp., has lost 0.3 percent in October, while Caesars’s $6.8 billion of the debt declined 1.13 percent, Bank of America Merrill Lynch index data show.
“It pays to be even more selective by credit” after this year’s rally, Pimco’s Jessop said. “You’ll start to see earnings will no longer be supportive for parts of the market.”
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