As Bond Market Rallies On, Risks Lurk Beneath Surface
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By MARK GONGLOFF / WSJ Oct 1, 2010
The bond market's flashy third quarter may have masked weak points that could affect it in the fourth quarter and beyond.
As they have for much of the past two years, investors in the third quarter continued to pour spare cash into bond funds and snub stock funds, as new-debt issuance broke records and interest rates fell toward generational lows. Individual investors put $87.7 billion into bond funds in the quarter while pulling $42.6 billion out of stock funds, according to the Investment Company Institute.
McDonald's, along with several other corporate borrowers, tapped the credit markets at some of the lowest rates in decades.
For all of that action, though, returns were fairly modest. High-yield corporate bonds returned 6.5%, investment-grade bonds returned 4.9% and Treasury debt returned 2.7%, according to Bank of America Merrill Lynch indexes. Those payoffs lagged behind sharp gains in stocks, with the Dow Jones Industrial Average gaining 10.4% on the quarter.
That relative underperformance by bonds is a reverse of the trend that has held for most of the year. The Dow Jones Industrial Average, for example, is up less than 3.5% this year, while high-yield bonds have returned 11.5%.
The shift in performance, if not investor attention, could signal the end of the easy money in the bond market. After a runaway rally that began in the depths of the credit crisis in late 2008, big gains in the bond market have been harder to come by lately. After returns of 94% and 46% for high-yield and investment-grade bonds, respectively, from their lowest point, further rewards may continue to be limited even as the risks rise.
To the extent that investors are more willing to take chances, either because of more Federal Reserve pump-priming through a bond-buying program or stronger economic data, bonds could continue to lag behind stocks. And while bond prices mightn't fall in such a scenario, investors could find other assets more rewarding.
"The Fed is trying to reflate the economy, and the asset class that could potentially benefit the most from that is the equity market," said Jason Quinn, co-head of high-grade and high-yield flow trading at Barclays Capital. "High-grade credit will benefit the least."
Still, with cash yielding next to nothing, slow economic growth and memories of multiple stock-market slides still fresh, investors are hungry for assets that churn out regular income and they are seeking them in the bond market.
Corporate treasurers have obliged by pumping the market full of fresh debt for investors to buy. High-yield borrowers, or those with credit ratings below investment-grade, issued nearly $190 billion in the third quarter, according to data provider Dealogic. The year has already broken the annual record for "junk bond" issuance, with one more quarter still to go.
Investment-grade issuance was nearly $612 billion in the third quarter, according to Dealogic. That issuance is off 2009's record pace, but demand for the debt of solid corporate borrowers such as Microsoft Corp., Johnson & Johnson and McDonald's Corp. was so strong that those companies were able to borrow at the lowest rates in decades.
Analysts expect another busy issuance calendar in the fourth quarter. Debt-finance chiefs at Bank of America Merrill Lynch, for example, are forecasting up to $175 billion in investment-grade bond issuance this quarter and $35 billion in high-yield issuance.
The combination of easy Fed monetary policy and other factors have put an extra $3 trillion in bond investors' pockets, estimates Jim Probert, Bank of America Merrill Lynch's head of investment-grade corporate bond and loan issuance for the Americas. That money needs somewhere to go.
"Though the supply of new bonds is great, it's not that much in the context of all of this demand," Mr. Probert said. "There's a pretty reasonable chance we will see more records broken" in corporate borrowing rates in the fourth quarter, he added.
The bull case for bonds depends in part on two beliefs. First is that the economy doesn't fall into a double-dip recession, which would drive higher default rates that have fallen to about 5% from a crisis high of 14.6%, according to Moody's Investors Service. Second is that the economy doesn't embark on a new boom, which would push investors into stocks. So far, so good on those fronts.
"High-yield companies don't need a lot of economic growth," said Todd Youngberg, head of High Yield at Aviva Investors North America. "They just need enough cash-flow generation to service their debt, and they want to refinance at a relatively attractive rate. That's the environment we have today."
One measure of how cheap refinancing costs are for companies is the gap between their bond yields and yields on risk-free Treasury debt.
For investment-grade bonds, that gap, or spread, tightened by about 0.25 percentage point in the quarter to 1.84 percentage points, the narrowest such spread since late May.
The spread between junk-bond yields and Treasurys tightened by more than 0.8 percentage point to 6.29 points, the narrowest since early May.
Historically, these spreads have been narrower—on high yield, notably, the spread got down to roughly 2 percentage points in 2007, just ahead of the financial crisis, and is typically closer to 5 percentage points, according to some sources.
Today's relatively wide spread suggests there may be more "juice in the tomato" of high yield, Mr. Youngberg said.
Mr. Youngberg believes the current spread is pricing in the risk of at least a 6% default rate among high-yield borrowers over the next 12 months. Moody's Investors Service, in contrast, expects a default rate of less than 3% during that time.
However, the outlook for corporate bonds could get grim if economic growth were to slow more sharply than most economists expect, pushing default rates higher.
Another minicrisis, such as a repeat of the spring's flare-up of sovereign-debt worries in Europe, also could cause corporate bonds to suffer.
"Going into the fourth quarter, demand for 'fear assets' is going to be pretty high," said Brian Yelvington, fixed-income strategist at Knight Capital. "That will severely limit risk-asset performance, including corporate bonds."
Other observers see the seeds of trouble being planted as weaker borrowers start to tiptoe back into the market to take advantage of investors' hunger for higher-yielding assets.
Weaker borrowers might offer higher yields, but they also carry greater default risks. A number have started to chip away at investor protections in their bond deals, "covenants" that limit corporate debt burdens, curb merger activity and otherwise help shield lenders from losses.
"I think those investors reaching for yield without understanding default risk, balance-sheet protection or the potential severity of losses are probably going to pay a price down the road," said Matt Freund, senior vice president of investment portfolio management at USAA, overseeing mutual funds with $43 billion under management. |
