March 4, 2013 3:13 pm

Warning signs for US corporate bonds

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Could the bond boom be turning? Warning signs are flashing as investors demand higher yields even on US bonds issued by the world’s largest and safest corporate borrowers.

In recent weeks, big investment grade bond issues by the likes of Philip Morris International and UnitedHealth Group have been sold at higher yields than the levels their older bonds were trading at in the secondary market.

Returns on IG bonds

Returns on IG bonds

The retreat in risk appetite comes after a frenzied period marked by record inflows into bond funds that has enabled companies to take advantage of cheap borrowing levels. Indeed, the sheer weight of money flowing into bond funds last year often resulted in companies being able to sell new bonds at a yield near or below where their existing debt was trading.

The recent emergence of a so-called price concession for big blue-chip bond deals also reflects the negative performance of investment grade so far this year, as well as poor liquidity in the secondary market and a notable slowing in new money flowing into bond managers’ portfolios.

“Investors are pushing back,” says Michael Collins, a senior investment officer at Prudential Fixed Income. “The bonds will have to pay higher premiums.”

Another factor making bond managers even more discerning over paying up for bonds has been the recent run of big buyouts of companies, which can result in their balance sheets becoming loaded up with debt, leading to lower credit ratings.

“High cash flow companies issuing bonds are going to find that investors will be wary of [leveraged buyout] risk,” says Jack Ablin, chief investment officer at Harris Private Bank. “No one wants to get stuck holding bonds in that situation.”

Rising interest rates may not just reflect deal risk.

The prospect of interest rate risk, whereby yields rise and spark price losses for investors, is also uppermost in the minds of investors, contributing to a more cautious approach to low yielding corporate debt.

“The latent interest rate risk in bonds is becoming a point of recognition for corporate bond managers,” says Edward Marrinan, head of macro credit strategy at RBS Securities.

Not surprisingly, money managers and bond investors are closely monitoring the discordant music coming from the Federal Reserve as officials publicly debate the pros and cons of continuing the central bank’s bond-buying programme throughout 2013.

Also unnerving investors in the sector is the lack of liquidity in secondary trading. Wall Street dealers have stepped back from supporting the market because of higher capital costs. The amount of bonds currently held by banks is less than a quarter of their $235bn peak seen in 2007, according to Federal Reserve data.

“Buying $150m of bonds at a new issue is very easy compared to turning around later and trying to sell $75m in the secondary market,” says Mr Marrinan. “That has portfolio managers turning defensive.”

The subtle shift in the demand side of the equation has prompted a change in companies coming to the market.

Buying $150m of bonds at a new issue is very easy compared to turning around later and trying to sell $75m in the secondary market

- Edward Marrinan, RBS Securities

Justin D’Ercole, head of the Americas investment grade syndicate at Barclays, says companies seeking to raise large amounts of funds have been structuring debt offers that, in addition to paying higher yield premiums, also include other features to entice investors, such as floating rate tranches.

“Investors are no longer blindly buying non-financial investment grade bonds at any price,” he says.

In one example last week, Philip Morris sold $1.85bn of bonds in three parts, including a $400m floating-rate tranche due in 2015 and $859m of notes due in 2043. The 30-year notes were sold at 4.29 per cent, roughly 14 basis points higher than the yield at which the company’s older 30-year notes were trading in the secondary market.

While yield concessions are climbing, levels are still much lower than the full percentage point demanded in the aftermath of the financial crisis and the collapse of Lehman Brothers. One could argue that valuations for corporate bonds are still reasonable with the Fed keeping a lid on interest rates.

But for those looking to “buy low and sell high”, investment grade bonds look expensive. They carry an average yield of 2.7 per cent in the US, while the S&P 500 is trading at an earnings yield of about 7 per cent based on this year’s expectations for earnings.

“There are more alternatives to [investment grade] bonds out there now,” says Mr Collins at Prudential.

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