Junk Bond Fever Building as High Grade Trails: Credit Markets
Investors are pumping money into junk bonds globally at the fastest pace ever while tempering their enthusiasm for higher-rated debt, demonstrating a preference for yield over stability.
Speculative-grade bond funds received a record $5.4 billion of deposits in the week ended July 24 while investors yanked $1.8 billion from investment grade, according to data from market researcher EPFR Global. Bond buyers are accepting the lowest yields in more than two years on riskier dollar-denominated debt relative to more creditworthy notes, Bank of America Merrill Lynch index data show.
Investors who abandoned junk bonds at a record pace in June are now casting aside concern that the securities will lose their allure as the Federal Reserve slows its record stimulus because of the extra yield the securities offer. The demand is allowing the neediest borrowers to ramp up indebtedness.
“High yield is far less vulnerable to a rise in interest rates than investment grade,” Gregory Kamford, a credit strategist at RBS Securities Inc. in Stamford, Connecticut, said in a telephone interview. The securities will “materially outperform investment grade over the balance of 2013,” he said.
Corporate bonds globally of all ratings lost 2.4 percent in June, the biggest decline since October 2008, after Fed Chairman Ben S. Bernanke said May 22 that sustainable labor-market progress could prompt policy makers to scale back $85 billion of monthly purchase of Treasuries (USGG10YR) and mortgage bonds.
Intelsat SA, the world’s biggest satellite services company, has led gains this month of 1.82 percent on junk bonds worldwide, the most in a year, after Bernanke said on July 17 that the U.S. central bank plans to “maintain a high degree of monetary accommodation.” Investment-grade notes have returned 0.9 percent.
The gap between yields on dollar-denominated high-yield and investment-grade bonds contracted to 3.18 percentage points on July 23 from 4.6 percentage points a year earlier as demand for the riskier debt surged, Bank of America Merrill Lynch index data show.
Investors poured $1.1 billion into exchange-traded funds that focus on dollar-denominated junk bonds in the five weeks ended July 17, compared with $173.8 million of withdrawals from investment-grade bond ETFs, according to data compiled by RBS.
“The Fed has successfully dampened volatility over the past few weeks,” Adam Richmond, a credit strategist at Morgan Stanley in New York, said in a telephone interview. “What has changed? Probably not much.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. increased, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 2 basis points to a mid-price of 76.3 basis points as of 12:21 p.m. in New York, according to prices compiled by Bloomberg.
The measure 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.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.2 basis point to 16.2 basis points as of 12:22 p.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.
Bonds of Morgan Stanley are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5 percent of the volume of dealer trades of $1 million or more as of 12:23 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Speculative-grade funds globally faced their biggest weekly outflow on record in the week ended June 26 with $6.8 billion of withdrawals, according to EPFR in Cambridge, Massachusetts. Yields on 10-year Treasuries soared to 2.74 percent on July 5, the highest since August 2011.
When Bernanke said on July 17 that the Fed’s asset purchases aren’t on a “preset course,” the market retraced some of the declines. “We’re going to be responding to the data,” Bernanke said in testimony before the House Financial Services Committee.
While high-yield debt has gained back more than half its 2.8 percent decline in June, investment-grade bonds have recouped less than a third of their return and have lost 1.2 percent since year-end.
High-yield bonds are graded below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
Bonds of Intelsat, the largest issuer of high-yield bonds in the U.S. this year, have gained 3.99 percent this month, the most among the biggest 50 borrowers in the Bank of America Merrill Lynch Global High Yield Index. Valeant Pharmaceuticals International Inc., the Laval, Quebec-based drug distributor acquiring Bausch & Lomb Holdings Inc., returned 3.88 percent.
Relative yields on high-yield bonds globally were 511 basis points on July 26 compared with the all-time low of 233 in June 2007, Bank of America Merrill Lynch index data show. Spreads on investment-grade notes of 150 basis points are up from this year’s low of 132 on May 28.
Luke Hickmore, an investment director at Scottish Widows Investment Partnership in Edinburgh, said his firm favors junk bonds over higher-rated debt.
“The difference between the absolute yield you get in high yield versus investment grade will grind tighter as slowing stimulus becomes a reality,” he said.
More volatility may be in the offing if the economy shows signs of improvement, flaring concern that the Fed will slow its bond purchases faster which would send yields soaring. Payrolls climbed by 202,000 a month on average from January through June, up from 180,000 in the second half of 2012, Labor Department figures show.
“We’ve been bearish on high yield for several months,” said Andrew Rabinowitz, a partner and chief operating officer of Marathon Asset Management LP, a hedge-fund firm that oversees more than $10.5 billion. “We’re still skeptics of it. It’s a yield play.”
Median leverage for high-yield companies has risen to 3.92 times from 3.42 times at the end of 2011, according to a June 3 report by Morgan Stanley strategists led by Richmond. Borrowers have sold $305.5 billion of speculative-grade bonds this year globally, more than the $206.5 billion issued in the same period last year, Bloomberg data show.
RBS strategists forecast that high-yield bonds will return 8.3 percent in 2013, compared with a 0.6 percent gain for investment-grade notes, Kamford said.
The 12-month trailing global speculative-grade default rate fell to 2.8 percent at the end of the second quarter from 3.1 percent in the same period last year, Moody’s said July 11. The ratings firm expects the rate to rise to 3.2 percent by year-end.
“Default rates are close to historic lows and are expected to stay that way for the foreseeable future,” Kamford said. “We prefer high yield versus investment grade due to the extra coupon cushion it provides.”
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