Bonds: What's Behind the Bounce in Corporates?

Even as equity indexes retested their November 2008 lows on Feb. 17, the bond market was telling a different story. Spreads between the composite yield on investment-grade corporate bonds and U.S. Treasury bonds of comparable maturity narrowed to their tightest levels since the beginning of the new year, indicating that investors have regained some appetite for corporate bonds even as equities resumed their slide. That's a far cry from the oft-heard remark last fall that if stocks were priced for an impending recession, corporate bonds were being priced for a depression.

Corporate bond yields, or the interest rate that bondholders earn, have dropped dramatically over the past three months, which means corporate bond prices have been rising. After reaching nearly 600 basis points in early December, the spread over Treasuries had narrowed to 470 basis points as of Feb. 17.

One reason for what Tom Murphy, manager of the Diversified Bond Fund (RDBIX) at RiverSource Investments (AMP) in Minneapolis, calls a "decoupling of equity and bond markets" recently is the absence of the forced selling by hedge and mutual funds that made both stock and debt investors skittish at the end of 2008. "Now people are doing a more rational analysis of the risk/reward [comparison] and can still get comfortable with that even as the equity market trades down to its lows," he says. "We need to continue to make progress. I'm not naive enough to think that if equities continue to test the lows, that the corporate debt market" can stay immune to stocks' downdraft.

Buffett Bullish on Tiffany

Billionaire investor Warren Buffett's investment in Tiffany (TIF) debt has also helped stoke more confidence in corporate bonds. On Feb. 12, subsidiaries of Buffett's company, Berkshire Hathaway (BRKA) bought $250 million of Tiffany's 10.00% Series A-2009 and Series B-2009 Senior Notes due in February of 2017 and 2019, respectively.

Murphy sees the investment as consistent with Buffett's purchasing preferred shares of companies after the Lehman Bros. collapse last September in order to have stakes higher up in the capital structure. "It's a high-profile example of people [looking at] the debt vs. equity trade-off at relative valuations and deciding they'd rather own the debt," he says.

Companies are returning to the credit markets— if not in a torrent, at least in a steady stream. On Feb. 17, DuPont (DD) sold $900 million of debt in a two-part sale, comprised of $400 million of six-year notes priced at a 4.75% yield and $500 million of 10-year notes priced at a yield of 5.75%. Both tranches were done at yields 313 basis points over comparable Treasuries, according to IFR, a Thomson Reuters service. The same day, Honeywell (HON) sold $600 million of 3.875% Senior Notes due 2014 and $900 million of 5.0% Senior Notes due 2019. Roche Holdings' (ROG.VX) offering on Feb. 18 was the biggest by far: a six-part sale in the private placement market worth a total of $16 billion, of which $13 billion has a maturity of two years or more.

Cisco Shows the Way

"Cisco [Systems] (CSCO) was the first one to put some size in there, and now everybody is following suit," says Bill Larkin, portfolio manager of fixed income at Cabot Money Management in Salem, Mass. What helped Cisco sell $4.0 billion of five- and 10-year notes on Feb. 9 for relatively small premiums over Treasuries was the fact that it's one of very few technology companies the market expects to weather the recession and continue to generate strong cash flow, he says.

Cisco had to agree to pay buyers of $2 billion in 10-year notes a coupon of 4.95%, roughly 200 basis points above the 10-year Treasury bond. That's quite reasonable, compared with the 550-basis point premium to Treasuries the company would have had to pay two months earlier to attract buyers, says Larkin.

As much as corporate debt spreads have narrowed in the past two months, they are still wide by historically standards, having been less than 100 basis points before the credit crunch began in 2007. Once the economy stabilizes and conditions start to improve, there will be lots of room for further tightening of spreads, says Murphy at RiverSource.

Special Programs Breed Confidence

It's prudent for underwriters to offer new issues at a nice discount relative to the prices at which existing bonds are trading in the secondary market in order to ensure sufficient participation so the deal will be oversubscribed, says Manny Labrinos, a corporate bond portfolio manager at Nuveen Asset Management in Chicago. "It's similar to the IPO market where you want to price it so it trades up rather than down" once it hits the secondary market, he says.

Total returns on investment-grade corporate bonds between Dec. 1 and Feb. 17 are 8.9%, as measured by Barclays U.S. Investment Grade Corporate Bond Index.

However encouraging the rally in corporate bonds since early December, the positive returns are being generated less by the fundamentals of an improving economic outlook than by confidence engendered by special programs guaranteeing certain kinds of debt introduced first by the Federal Reserve and more recently by the U.S. Treasury Dept., according to Mike Brandes, senior fixed-income strategist at Smith Barney, a division of Citigroup (C). "There's an extraordinary appetite for investment-grade paper, partly triggered" by the Fed's promise to purchase $100 billion of government agency debt and $500 billion of agency mortgage-backed securities and the FDIC's Temporary Liquidity Guarantee Program (TLGP), he says.

Large Deals Boost Liquidity

Indeed, the TLGP contributed 14 bond offerings worth $39.7 billion, or over 31% of the 94 deals worth a total of $127.1 billion with maturity greater than 18 months done this year through Feb. 17 by investment-grade U.S. companies, according to Dealogic, a research firm in New York.

One benefit the larger-size debt issues has had is to boost liquidity of those bonds when they start to trade in the secondary market, which can bolster confidence in the corporate bond market.

Labrinos at Nuveen sees liquidity in high-quality investment-grade bonds improving and is now a much smaller concern among bond investors than it was a few months ago. The larger size of bond offerings has made the major Wall Street firms more willing to make a market in certain issues that they don't own but that clients are requesting since they're confident they'll be able to easily buy back bonds to cover short positions if needed without having to pay a premium.

The key question investors should be asking is whether a bond has already priced in ratings downgrades that are likely to happen, says Labrinos. "If you're holding a single-A bond already trading at spreads reflective of triple B bonds and you think it's going to get downgraded to triple B and stay there," you'll be willing to buy it at the current price, he says. It all comes down to what rating you think the bond will ultimately settle at once this tough credit cycle ends.

Top-Quality Companies Benefit

For his part, RiverSource's Murphy is relying less on the rating agencies and more on his own models to determine companies' credit quality.

Ultimately, the current thaw in the corporate market remains limited to the companies on the upper rungs of the ratings ladder. The fact that more than $100 billion of investment-grade bonds have been issued so far this year demonstrates that access to the capital markets for high-quality non-cyclical companies is improving, but that doesn't mean that low-triple B cyclical companies will be able to get a bond offering done in the next three to six months, says Murphy. "The market's not there yet," he says. For now, bond investors appear content to nibble at the offerings of higher-quality names.

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