Opinion

James Saft

Corporate bond risk gets silly once again: James Saft

December 19, 2012

Dec 19 (Reuters) – Proving yet again that history rhymes
rather than repeats, just a few short years after an epochal
crash the search for yield just gets wilder and wilder.

Perhaps the best place to see this is in the corporate bond
market, where yields are at or near all-time lows while, by some
measures in key sectors, investor protections have never been
weaker.

Don’t expect, though, to see a repeat of the bloodbath of
2008 and 2009, when markets froze and there was real fear that
normally viable companies would as a result hit the shoals. For
one thing, companies are more liquid and less leveraged.

Instead, the big risk for 2013 is that higher overall
interest rates make bonds issued in 2012′s rock-bottom rate
environment into big, but not catastrophic, losers.

Corporate borrowers have been a prime beneficiary of
monetary policy, as trillions of Federal Reserve bond buying
freed up money which then sought higher, if not safer, returns
elsewhere. That, indeed, was part of the plan, and investors
have streamed into riskier and higher yielding corporate bonds.

Little wonder, given that many investors, particularly
pension funds, have yet to sufficiently recalibrate their annual
return goals to suit a low-growth, low-return world. If you are
going to hold a third of your portfolio in fixed income, but
hope to make 8 percent overall, the only way to do it with
10-year Treasury yields at 1.78 percent is to take on a whole
lot of extra risk.

Many have also talked themselves into thinking that the best
companies are the new sovereign credits, using the crisis in
Europe and the downgrade of the U.S. as an argument for
re-allocating into high-rated corporate debt. Stop me if I am
wrong, but last I checked even the best-rated corporation hasn’t
got either a printing press to create money or the power to
impose taxes.

The numbers coming out of the corporate bond market are
striking.

The yield on the benchmark BofA Merrill Lynch US Corporate
Master index was last seen at a measly 2.84 percent, near
life-time lows set earlier this month. The yield on the BofA
Merrill high-yield index of the bonds of riskier companies was
just 6.23 percent, an all-time low.

On a spread basis, which measures the compensation investors
get above what Treasuries pay, things are not quite as bad. For
high-yield bonds, spreads are 5.19 percent, well above where
they were during the boom years in the early part of the last
decade. For high-grade corporates the spread, while only about
1.5 percent, still compares favorably to the 1 percent or so
that prevailed before the crash.

Many argue that companies represent less risk than before
the crash, and on some measures that is true. Leverage, outside
of certain narrow segments, is generally lower, and companies
have learned the lesson of the crash, cleaning up their balance
sheets and maintaining better access to cash and working
capital.

IF RATES RISE

The big difference between now and then, however, is market
interest rates. Before the crash so-called risk-free Treasuries
had much more symmetrical risk, meaning there was plenty of room
to rally as well as plenty of room to move against investors.
Now, unless you believe rates will go negative, overall risk is
skewed against investors.

Fitch Ratings recently estimated that the average 10-year
BBB-rated U.S. corporate bond issue would lose 15 percent of its
value if Treasuries only rise to where they were in early 2011,
about two percentage points higher than currently. Even a
one-point rise in rates would shave 8 percent off of the value
of the same bond.

High-yield bonds will show negative returns in 2013,
according to veteran high-yield analyst Martin Fridson, of
FridsonVision LLC, who bases his call on the market’s
expectation of rising Treasury yields next year.

“The difference between the high-yield return and the
five-year Treasury return in environments like the present one
has averaged negative 2.17 percent,” he wrote in a note to
clients.

Even if you don’t believe market rates will move higher,
there is plenty to be worried about in the riskier segments of
the corporate bond markets, where issuers have taken the
opportunity to again winnow away the strictures that have
traditionally protected investors. According to ratings agency
Moody’s the quality of covenants, limitations outlined in a bond
to protect the interest of creditors, was at a record low for
bonds issued in November.

Any sensible investor will demand more security for taking
more risk, right? Not in the high-yield bond market of 2012, she
won’t. Reversing a trend which has to be seen as the natural
order of the universe, in parts of the credit spectrum the lower
the borrowers rating the worse covenant protection became.

For corporate bond investors 2013 looks likely to rhyme with
2008, though it will be a downbeat dirge rather than the funeral
march of the crisis.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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