Bond Traders Confront Inflation From Vulnerable PositionsSridhar Natarajan
The green shoots of inflation are coming at about the worst time for corporate-bond investors.
A measure of the U.S. investment-grade corporate bond market’s sensitivity to rising interest rates, known as duration, is approaching the record high reached last year before a selloff in fixed-income assets wiped $230 billion from the value of company debt, Bank of America Merrill Lynch index data show.
Investors are suddenly cognizant of inflation, which erodes the value of fixed interest payments over time, after a government report yesterday showed consumer prices jumped in May by the most in a year, raising pressure on the Federal Reserve as it debates when to raise rates. Investors in two 30-year bonds issued this month -- a $1 billion offering from Home Depot Inc. and $800 million of securities sold by International Paper Co. -- suffered losses as yields rose.
“Anybody with long duration might get caught up in a sharp increase in rates and is going to feel the pain,” said Rick Tauber, an analyst at Chicago-based researcher Morningstar Inc. “When things move, they tend to move pretty quickly.”
The effective duration of bonds in the Bank of America Merrill Lynch U.S. Corporate Index has increased to 6.8, close to the peak of 6.9 recorded in May 2013, before the Fed started dropping hints it would move to scale back bond purchases that have suppressed interest rates. The measure dropped to an almost two-year low of 6.4 in August as investors fled longer-maturity debt at the fastest pace since the onset of the credit crisis.
A patchy recovery, hamstrung by contraction in the world’s largest economy in the first quarter, prodded investors back into longer-dated securities, which generally pay higher yields than shorter-term debt, as Fed officials led by Chair Janet Yellen damped concerns the central bank would start raising rates sooner than anticipated.
“Buyers are hungry for yield because they have to show some sort of return,” William Larkin, a money manager at Cabot Money Management said in a telephone interview. “We are all trying to find something of value.”
The push deeper into fixed-income markets upended estimates for more bond losses in 2014, with yields on 10-year Treasuries declining 0.4 percentage point since the start of the year to 2.65 percent yesterday.
Dollar-denominated, high-grade notes coming due in more than 10 years have returned 11 percent this year, compared with gains of 5.2 percent for a broader index, data compiled by Bloomberg show. The outperformance has emboldened investors to snap up new long-term debt, such as Johnson Controls Inc.’s $450 million offering this month of 4.95 percent securities maturing in 2064. Caterpillar Inc., the largest maker of mining and construction equipment, sold $500 million of 4.75 percent, 50-year bonds last month.
“We scratch our heads a little bit when we see those,” Morningstar’s Tauber said.
U.S. corporate borrowing costs have plunged back toward the record lows reached last year with the average yield on investment-grade securities at 3.1 percent, index data show.
Investors’ latest embrace of long-term debt comes as economists surveyed by Bloomberg News signal the market is underestimating the pace of Fed tightening over the next two years, according to 55 percent of economists in the June 12-16 survey.
The consumer price index increased 0.4 percent, the biggest advance since February 2013, after climbing 0.3 percent the prior month, a Labor Department report showed yesterday in Washington. The median forecast of 81 economists surveyed by Bloomberg called for a 0.2 percent increase. Excluding volatile food and energy prices, the gain was the largest in almost three years.
International Paper’s 4.8 percent bonds due in 2044 fell 0.9 cent yesterday to 99.1 cents on the dollar, the biggest decline since their June 3 offering, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The yield climbed to 4.85 percent. Home Depot’s 4.4 percent debt due in 2045 dropped 0.8 cent to 99.4, yielding 4.44 percent.
The duration measure is used as a gauge to determine the susceptibility of fixed-income securities to a change in interest rates. Effective duration has averaged 6 for investment-grade securities since 2000, Bank of America Merrill Lynch index data show.
“It’s a little bit of investor complacency,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., said in a telephone interview. “I think a part of it is the fact that some investors are throwing in the towel. It’s been a strong year for bond performance, and certain investors are not only complacent but are also trying to chase the performance.”
When the previous Fed Chairman Ben S. Bernanke told Congress in May 2013 that the central bank’s policy-setting committee could start scaling back debt purchases that at the time totaled $85 billion a month, it triggered losses across the board.
The yield on 10-year U.S. government debt surged more than 100 basis points in about two months, with investment-grade bonds losing 6.2 percent in that period.
Fed officials predicted their target interest rate will be 1.13 percent at the end of 2015 and 2.5 percent a year later, the Federal Open Market Committee said today in a statement in Washington. That’s higher than their previous forecast of 1 percent and 2.5 percent.
“One risk of rising duration is that it is going up when yields are very low,” Valeri said. “A smaller change can lead to more damage than investors might have anticipated. There’s less yield to provide a buffer to price declines associated with rising rates.”