Hardest-to-Sell Junk Lures Buyers Hooked on Fed: Credit Markets
The extra yield investors demand to buy the least-traded bonds with the lowest speculative-grade ratings instead of more liquid securities narrowed to 1.2 percentage points on April 9, the smallest gap since November 2011, according to Barclays Plc (BARC) data. Yields on the smallest and oldest CCC rated notes contracted by 1.9 percentage points this year, three times the drop on yields for more active notes with comparable grades.
Bond buyers seeking to escape the financial repression brought on by near zero interest rates are venturing deeper into the market in search of returns. They are bidding up the debt of companies that would otherwise be the most vulnerable to bankruptcy had the Federal Reserve not injected more than $2.3 trillion into the financial system since 2008.
“People are more willing to take on less liquid names because they’re not as worried about having to harvest or sell them due to credit reasons,” said Jason Rosiak, head of portfolio management at Newport Beach, California-based Pacific Asset Management, the Pacific Life Insurance Co. affiliate that oversees about $3.5 billion. “People’s expectations right now are that credit fundamentals aren’t going to take a downturn any time soon.”
More than four years after the worst financial crisis since the Great Depression, investors are casting aside fears of credit losses as they search for returns. With the Fed holding interest rates between zero and 0.25 percent for a fifth year, junk-bond yields plummeted to a record 6.35 percent yesterday, according to Bank of America Merrill Lynch index data.
The lowest-tier of dollar-denominated speculative-grade bonds are outperforming the highest-rated notes by 3.5 percentage points this year as investors funnel cash into debt with bigger cushions from losses when U.S. Treasury yields rise.
“The market is increasingly willing to accept less of a premium for both age and size,” said Eric Gross, a Barclays credit strategist in New York. “It’s somewhat similar to when we saw that hunt for yield in early 2010.”
Elsewhere in credit markets, the market for corporate borrowing through commercial paper erased last week’s decline, led by a surge in issuance from financial institutions. The cost of protecting corporate debt from default in the U.S. reached the lowest level in more than three weeks.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 0.1 basis point to a mid-price of 81.9 basis points as of 11:43 a.m. in New York, according to prices compiled by Bloomberg. The index earlier fell to as low as 81.5, the least since March 19, the day before traders began moving positions into a new series that increased the cost in part by adding six months to the contracts.
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.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.47 basis point to 14 basis points. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Fairfield, Connecticut-based General Electric Co. (GE) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.2 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.
The seasonally adjusted amount of U.S. commercial paper rose $19.5 billion to $1.022 trillion outstanding in the week ended yesterday, the Fed said today on its website. The market, which contracted by that amount the previous week, has climbed from $924.4 billion in the week ended Oct. 24, the lowest level since January 2011.
Commercial paper sold by non-U.S. financial institutions rose for a fifth week, increasing $9 billion to $236.8 billion outstanding, while the amount issued by U.S.-based banks rose $3.6 billion to $301.6 billion, the first increase in six weeks, according to the Fed.
Corporations sell commercial paper, typically maturing in 270 days or less, to fund everyday activities such as rent and salaries.
Junk-bond investors demonstrated a preference for the most- liquid debt in the wake of the credit crisis, as dealers faced with risk-curbing regulations reduced corporate-bond inventories that they use to facilitate trading by 76 percent since the peak in October 2007.
Yields on CCC rated bonds sold more than 18 months ago in batches of $400 million or less have dropped to 8.78 percent on April 9 from the two-year high of 14.3 percent on Oct. 5, 2011, Barclays data show. That compares with a 7.58 percent yield on bigger issuances sold more recently, down from 13.5 percent 18 months earlier, the data show.
“You’re seeing people willing to take on the risk of lower-quality names,” Rosiak said.
A measure of the strength of junk-bond covenants in North America written into the terms of debt agreements over the past three months to protect investors deteriorated to a record low, Moody’s said yesterday.
The average covenant score, in which 1 is the strongest covenant quality and 5 the weakest, worsened for a third period to 3.97 last month, according to Moody’s Covenant Quality Index. While March’s single-month score of 3.76 improved from 4.17 in February, it’s still the fifth-worst monthly score during the past year, Moody’s said.
The lowest-tier of junk debt in the U.S. has returned 5.8 percent this year, compared with 2.2 percent on bonds with the highest junk grades, Bank of America Merrill Lynch index data show. While notes graded CCC gained 20.3 percent in 2012, they lost 1.4 percent the year before, when securities in the top junk tier of BB gained 6.1 percent, according to the data.
Firms from Ares Management LLC to Pacific Investment Management Co. are raising money for closed-end funds that may invest in harder-to-trade debt. Ares, based in Los Angeles, is planning a fund that will use borrowed money to buy mostly high- yield loans and bonds, according to a March 20 regulatory filing.
In January, Pimco raised about $3 billion for its Dynamic Credit Income Fund (PCI) that may invest all of its money in speculative-grade debt, including notes from “stressed issuers,” according to a Jan. 28 prospectus.
“Investors who don’t need daily liquidity can take greater advantage of the smaller, less liquid situations which may potentially offer greater upside,” said Hozef Arif, a senior vice president and portfolio manager at Pimco in Newport Beach, California.
Speculation that an expanding economy will prompt Fed officials to start scaling back stimulus efforts, pushing rates higher and investors into stocks, isn’t likely to play out anytime soon, said Bruce Richards, chief executive officer and co-founder of hedge-fund firm Marathon Asset Management LP.
“As an investor, if you were in the marketplace, you do not have a lot of worry that rates will go higher,” Richards said in an interview on Bloomberg Television’s Market Makers with Erik Schatzker and Stephanie Ruhle. “This calendar year, while we are doing quantitative easing, while Fed Funds are zero, I don’t think you’ll have that great rotation.”
Japanese investors are also poised to accelerate debt purchases as that nation’s central bank plans to buy 7.5 trillion yen ($78.6 billion) of bonds a month and double the monetary base, which includes cash in circulation, in two years, the central bank said in Tokyo on April 4.
High-yield bond buyers are turning their focus to choosing specific bonds rather than making broad wagers on a market that’s reaped average annual gains of 21 percent since 2008, Bank of America Merrill Lynch index data show.
“Credit selection will be the driver of alpha in these markets, where yield and spreads are in a narrower range,” Arif said.
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