JPMorgan as Biggest Underwriter Sees More Losses: Credit Markets

The chief market strategist at JPMorgan Chase & Co., the world’s biggest underwriter of corporate bonds, says the worst first half of the year on record for the securities may only deepen.

The notes have lost 3.7 percent on average since May 22 when Federal Reserve Chairman Ben S. Bernanke told Congress the central bank may begin curtailing its unprecedented stimulus program if economic conditions warrant, Bank of America Merrill Lynch index data show. The losses compare with a drop of 2.9 percent for government securities.

The performance is a shock to bulls who expected the extra yield offered by corporates relative to government bonds to cushion any selloff that stemmed from the prospects for higher interest rates and a stronger economy. Instead, diminished dealer inventories of the securities brought on by regulatory changes has caused liquidity to drop, exacerbating the price declines.

“Through a whole set of new, post-crisis regulations, the potential buyers do not have the same capacity to absorb credit risk,” said Jan Loeys, who heads a global asset allocation strategy team at JPMorgan in New York, in a telephone interview. “The banks don’t have the same ability to absorb this anymore.”

Dealer Holdings

The 21 primary dealers that do business with the Fed reduced their net long-term investment-grade bond holdings by 22 percent since April 3, when the central bank began reporting more granular data, to $8.77 billion on June 26.

Investors have yanked about $60 billion from U.S. bond funds since Bernanke told Congress that the central bank may start reducing its $85 billion of monthly debt purchases if the labor market continues to improve and “we have confidence that is going to be sustained,” according to the Washington-based Investment Company Institute.

Buyers are trying to shield themselves from losses after purchasing $16.4 trillion of corporate debt since 2008, with yields plunging to an unprecedented low of 3.09 percent on May 2, according to Bloomberg and Bank of America Merrill Lynch index data. They’ve since risen to 3.88 percent, eating away almost $400 billion of market value from bonds that have a face value of about $9 trillion.

JPMorgan underwrote $140 billion of corporate debt this year, or 6.9 percent of the market, according to data compiled by Bloomberg.

‘Tactically Underweight’

“We continue to be concerned about the rotation out of high-grade bond funds, as flows follow returns, and remain tactically underweight high grade,” wrote Bank of America Corp. strategists led by Hans Mikkelsen in a July 5 report. “We are very concerned about the process of market capitulation toward the view of significantly rising interest rates without another opportunity to offload duration at higher prices.”

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. fell for a second day. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreased 2.3 basis points to a mid-price of 81 basis points as of 12:11 p.m. in New York, according to prices compiled by Bloomberg.

Default Swaps

The credit-default swaps index, at the lowest level on an intraday basis since June 19, typically falls as investor confidence improves and rises as it deteriorates. The contracts 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 1.3 basis points to 16.5 basis points as of 12:12 p.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Bonds of Goldman Sachs Group Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.8 percent of the volume of dealer trades of $1 million or more as of 12:12 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Bloomberg Global Investment Grade Corporate Bond Index has lost 0.63 percent this month, bringing the decline for the year to 4.62 percent.

Spreads Widen

Relative yields on company bonds have widened 39 basis points since May 22, when Bernanke signaled the Fed may slow its stimulus this year, to 232 basis points, Bank of America Merrill Lynch index data show. During that period, yields on 10-year U.S. Treasuries rose 60 basis points, to 2.64 percent, Bloomberg data show.

While the extra spread on corporates acted in the past to absorb interest-rate rises, they aren’t doing this now because credit gained the most from the “search for yield” fueled by the stimulus policies of central banks globally, according to Loeys. He said that “weak secondary markets means there is probably pent-up selling pressure” making it too early to take a bullish view on credit.

“In the past, the duration positions were in Treasuries and now they’re not in Treasuries, they’re in credit,” said Loeys, who said his view doesn’t represent the entire bank. “The desire is to get rid of credit. Treasuries are already shorted.”

Music ‘Stopping’

Issuance surged to unprecedented levels as companies sought to take advantage of plummeting yields resulting from the Fed’s bond-purchasing program, which has pumped more than $2.5 trillion into the financial system since 2008.

Fed policy makers said June 19 after a two-day meeting that downside risks to the economy have “diminished.” Bernanke said in a news conference the same day that the central bank may probably begin tapering its asset purchases later in 2013 and end them around mid-2014, provided the economy performs in line with its projections.

“Everybody was happy as it happened,” Loeys said. “Now the music is stopping and investors are trying to reduce and they can’t.”

Average daily trading volumes on high-yield corporate bonds have fallen 6 percent since May 22 compared with the earlier part of the year, according to Trace data. Volumes have dropped 4 percent for investment-grade bonds.

Biggest Challenge

Primary dealers cut their corporate-debt inventories by 76 percent from the peak in October 2007 through the end of March as the 27-country Basel Committee on Banking Supervision raised minimum capital requirements in 2010 and U.S. Congress passed the Dodd-Frank Act.

Wells Fargo & Co. Chief Executive Officer John Stumpf said on May 30 that the biggest challenge to bankers is managing the risk of losses resulting from rising interest rates. Goldman Sachs Chief Executive Officer Lloyd C. Blankfein warned on May 2 that the interest-rate environment has parallels to 1994, when a sudden and sharp increase in rates caught many investors off-guard.

“The problem is not higher interest rates in themselves -- higher rates are normally good for credit spreads -- but the rate of increase in rates,” Bank of America’s Mikkelsen wrote in the July 5 report. “At some point something has to give.”

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