BofA Says Bonds to Beat Stocks in Debt Gridlock

Strategists from Bank of America Corp. to Wells Fargo & Co. predict dollar-denominated corporate bonds will outperform stocks this month if political gridlock persists with the government partially shut down this week.

Company debt in the U.S. has gained 1 percent since Sept. 17, the day before the Federal Reserve surprised investors with its decision to maintain unprecedented economic stimulus, compared with a 0.5 percent decline on the Standard & Poor’s 500 Index. In August 2011, the last time legislators approached a deadline to raise the debt limit, investment grade bonds returned 0.13 percent while U.S. stocks declined 5.4 percent.

“Investment-grade credit can produce attractive risk-adjusted returns relative to equities or other risk assets,” Edward Marrinan, a credit strategist at Royal Bank of Scotland Group Plc’s securities unit in Stamford, Connecticut, said in a telephone interview. “If there’s an asset class that’s more vulnerable amid a protracted government shutdown and a contentious debt-ceiling debate, it’s equities.”

Even with corporate bonds trading at yields within a percentage point of all-time lows, they’re set to perform better than stocks this month, according to Bank of America’s Michael Contopoulos, as any weakening of the economy resulting from the shutdown will likely prolong the Fed’s $85 billion of monthly purchases of mortgage bonds and Treasuries.

‘Serious Consequences’

“If negotiations in Washington continue to be unfruitful, stocks will be more vulnerable than credit,” Contopoulos, a high-yield credit strategist in New York, wrote in a Sept. 26 report. “The focus away from increasing rates to the rising probability of a government shutdown implies that equities are likely to underperform credit over the next month.”

Congress’s failure to pass a budget by Sept. 30 partially closed the government yesterday for the first time in 17 years, costing the U.S. at least $300 million a day and setting the stage for a debate on raising the U.S. debt ceiling.

The shutdown temporarily put as many as 800,000 federal employees out of work, halting some government services. Gridlock over the budget or a failure to raise the debt limit “could have very serious consequences” for the economy and policy makers will have to take that into account, Fed Chairman Ben S. Bernanke said Sept. 18 at a news conference in Washington after the central bank’s decision was released.

Volatility Rise

Investors funneled $2.9 billion into U.S. high-yield bond funds last week, the second-highest inflow this year, and $1.7 billion into investment-grade funds, the most in 17 weeks, Bank of America data show. Yields on dollar-denominated corporate bonds have narrowed 9 basis points since the end of August, to 4.12 percent from this year’s high of 4.37 percent on Sept. 5, Bank of America Merrill Lynch index data show.

The bond gains follow a 2.3 percent loss in the first six months of the year on the Bank of America Merrill Lynch U.S Corporate & High Yield Index, when investors demonstrated mounting concern that the U.S. economy had improved enough for the Fed to start reducing its bond purchases. The S&P 500 posted a total return of 13.8 percent in the period, its biggest gain since 1998.

“We’re going to see an increase in volatility surrounding this debt ceiling debate” in the equity markets, said Scott Wren, a senior equity strategist at Wells Fargo Advisors LLC, the subsidiary of Wells Fargo that oversees about $1.3 trillion of assets. If stocks sell off, he said, “you’d see bonds rally from here.”

Default Swaps

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 1 basis point to a mid-price of 80.4 basis points as of 11:08 a.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 0.06 basis point to 13.5 basis points as of 11:06 a.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.

Verizon Bonds

Bonds of Verizon Communications Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 7.4 percent of the volume of dealer trades of $1 million or more as of 11:06 a.m. in New York, Trace data show. The New York-based telephone carrier raised $49 billion on Sept. 11 in the largest corporate bond issue ever.

Dollar-denominated investment-grade and high-yield bonds returned 1.18 percent in the three months ended Sept. 30, the biggest quarterly gain this year, according to Bank of America Merrill Lynch index data.

The notes gained 0.9 percent last month as Bernanke said policy makers are “somewhat concerned” by tightening financial conditions and decided to keep their current level of asset purchases as a “precautionary step.”

On the day the Fed said it would keep buying $45 billion of Treasuries and $40 billion of mortgage bonds until at least its next meeting this month, yields on 10-year Treasuries plunged the most since November 2012 from 2.99 percent on Sept. 5, the highest since July 2011.

Honeywell, JetBlue

“We believe the 10-year Treasury yield will be meaningfully lower than where it is today,” RBS’s Marrinan said. “Treasuries and investment grade will be the primary beneficiaries if the government shutdown is so protracted that it runs into the debt-ceiling debate later this month.”

Chief executive officers at companies ranging from Honeywell International Inc. to JetBlue Airways Corp. said that a prolonged shutdown of the U.S. government has the potential to jeopardize the economic rebound.

The first partial shutdown in 17 years may subtract as much as 1.4 percentage points from economic growth, depending on its length, according to Guy LeBas, chief fixed income strategist at Janney Montgomery Scott LLC in Philadelphia. A lengthy budget fight risks damping consumer sentiment, cooling the auto market, restraining sales of luxury goods and hurting travel.

“Until there is a meaningful pick up in the data and a corresponding rapid rise in rates fueling outflow concerns once again, there seems to be limited impetus for credit to widen meaningfully,” the Bank of America credit strategists wrote. “Yet another long drawn debate around raising the debt ceiling can only be a negative for risk assets.”

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