Bonds Upended as AAA Yields Exceed AAs on TaperingMatt Robinson
Corporate bonds with AAA ratings are yielding more than debt graded a tier lower, a divergence that’s happened only twice in the past decade as investors sour on securities with the most to lose when interest rates rise.
The average yield of 2.86 percent for $34.2 billion of the highest-rated bonds in a Bank of America Merrill Lynch index on Aug. 13 was 0.27 percentage point more than the average for AA bonds. The last time that happened was in early 2009, when derivative traders roiled by the worst financial crisis since the Great Depression were treating then-AAA borrower General Electric Co. like junk.
Speculation that the Federal Reserve may pull back on its unprecedented stimulus measures as soon as next month is roiling the bond market as investors shift away from securities likely to be hurt by rising rates. A measure of sensitivity to benchmark rates is about the highest for AAA bonds relative to AA debt in at least a decade, the Bank of America Merrill Lynch index data show.
“Investors have been grabbing credit risk over interest-rate risk, so there’s more desire for lower credits and a little bit less desire for the AAA credits,” said George Rusnak, the national director of fixed-income for Wells Fargo Private Bank in Philadelphia, which manages $170 billion. “Ultimately, if there’s significant dislocation between the two, people are going to exploit that.”
The divergence is leaving debt sold by AAA rated Johnson & Johnson, the 120-year-old maker of health-care products from Band-Aid bandages to Tylenol, yielding an average 3.1 percent as of yesterday, 1.2 percentage points more than securities issued by Google Inc., the Internet search engine owner that’s graded two steps lower.
The effective duration for debt of New Brunswick, New Jersey-based J&J was 9, compared with 4.8 for Mountain View, California-based Google, Bank of America Merrill Lynch index data show. A greater duration signals higher sensitivity of bond prices to changes in interest rates.
The duration for all AAA rated debt has climbed to 8, close to the record 8.2 reached last month and up from 5.7 at the end of 2008, Bank of America Merrill Lynch index data show. That compares with a 6.14 duration for AA graded bonds, which has risen from 5.5 in December 2008.
“We’ve seen a revisit and comfort moving back into lower rated” securities, Mark Pibl, the head of credit strategy at Pierpont Securities LLC in New York, said in a telephone interview.
Elsewhere in credit markets, the cost to protect against losses on corporate bonds in the U.S. reached a more than one-month high. The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased for the fourth day this week.
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, rose 1.9 basis points to a mid-price of 79.7 basis points as of 12:02 p.m. in New York, according to prices compiled by Bloomberg. The index is heading for the highest closing level since July 10.
In London, the Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, declined 0.1 to 99.
The indexes typically rise as investor confidence deteriorates and fall as it improves. 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 two-year U.S. swap spread rose 1 basis point to 18.75 basis points, the highest since July 5. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.
Bonds of Charlotte, North Carolina-based Bank of America Corp. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.8 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.
Yields on AAA bonds inverted with the lower-rated debt in January for the first time since March 2009, when yields on the highest-ranked bonds surged to as high as 8.27 percent amid the financial crisis.
Bonds issued by GE’s finance unit rose to more than 9 percent that month and traded as if the company were rated Ba1, one step below investment grade, according to data compiled by Moody’s Corp.’s capital markets research group. Moody’s and Standard & Poor’s both stripped GE of its top rankings the same month.
The importance of holding a AAA rating in the corporate-bond market has lessened as interest rates fell to unprecedented lows. The number of non-financial AAA companies in the U.S. has dwindled to four from more than 60 in the early 1980s, according to S&P.
Pfizer Inc., the world’s largest drugmaker, lost its AAA rating from S&P in October 2009, about three years after Moody’s cut its grade on the company. Warren Buffett’s Berkshire Hathaway Inc. was stripped of its AAA rating by Moody’s in April 2009 and by S&P the next year.
“There’s a limited number of names,” said Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion. “There’s not much way to get diversification in higher-quality corporates.”
The extra yield investors demand to own AAA bonds instead of similar-maturity Treasuries has narrowed to 71 basis points, 18 basis points less than yield spreads on AA debt, Bank of America Merrill Lynch index data show. The spread gap has narrowed from a more than two-year wide of 112 basis points in October 2011.
Fed Chairman Ben S. Bernanke has sent Treasury yields higher this year after outlining a plan in June that the central bank could start curtailing the current pace of bond buying this year and end them around mid-2014 if growth is in line with the central bank’s estimates.
Yields on 10-year Treasuries, a benchmark for corporate and consumer borrowing rates, jumped to as high as 2.82 percent yesterday, the highest intraday level in more than two years.
Rising long-term interest rates are prompting investors to seek out shorter maturing corporate bonds, LPL’s Valeri said. The average yield on 30-year Treasuries has climbed to 3.46 percentage points more than those for two-year notes, Bloomberg data show.
Sales of three-year debt made up 25.8 percent of U.S. investment grade offerings last month, the most since April 2011, Bloomberg data show. Offerings of 30-year debt fell to
5.39 percent in July, down from this year’s peak of 11.6 percent in May.
“AAA isn’t what it used to be,” Valeri said. “The market views AA as very good quality and it gets lumped in together with AAA.”
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