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Corporate Bond Spreads and the Bond Orgy


Current headlines do not reflect the type of behavior and attitudes seen at the end of a credit cycle.

I have received some questions on Twitter asking why the recent rise in high-yield spreads isn't at least the sign of a change in trend, and at worst something that will derail the corporate bond market and consequently the stock buybacks, which have been behind much of the rise in equity prices. Since these questions go to the very heart of my argument that the dynamic of corporate bond sales and stock buybacks has a long way to go before blowing up, I want to quickly revisit where we stand in terms of absolute rates of interest, and why a pullback in bond prices may actually accelerate the pace of bond sales and ultimately of buybacks.

First off, below is the weekly chart of the Barclays High-Yield Index Bond (NYSEARCA:JNK). As you can see, despite the near 1% rise in spreads from the recent lows, this increase hardly even registers, considering where we were and how far we have come.

Second, approximately half of the increase is due to the underlying rise in treasury rates. So if the concern is that the widening of spreads is a consequence of higher risk premiums in high-yield bonds, that increase so far has been truly negligible.

Third, I would argue that the rise in rates we have seen so far is more a function of buyers, rabid as they may be, digging in their heels and refusing to buy bonds for nearly no return. To continue the flood of demand for bonds, sellers must periodically accept higher interests as an incentive for buyers to keep showing up with cash. If you think about it, a company that wants to sell $1 billion worth of bonds to buy back its stock is hardly going to care if it has to pay a few more basis points per year. All it cares about is whether there be a buyer willing to give it that money.

I submit to you that even if rates were to rise several hundred basis points, and even if we were to see a lull in bond issuance (we saw some signs of that last week), it would not necessarily mean that the party is over. Yes, it might worry some traders, and it will likely make headlines, but ultimately as long as the bond buyers show up again, as they have time and time again since January 2009, we are going to have this very same discussion when spreads will have again tightened and hundreds of billions of dollars per month are again flowing into corporate bonds.

Now, why I think this is just a pause rather than the beginning of the end is a question much more easily answered in hindsight. But as long as we see a continued appetite for credit risk even in the face of rising rates, I am willing to make the leap of faith that bond buyers will be back. Let me give you some examples.

These are some of the headlines, mostly from the daily "Bloomberg Brief" on leveraged finance, that I spotted just during last week:
  • Morgan Stanley (NYSE:MS) arranged a €303 million European CLO for a client; the deal was increased from 253 million euro;
  • "investors added $988 million this week to funds that purchase loans, pushing year to date deposits to more than $28 billion….That represents an increase of about 36% in net assets for the year, outperforming funds that purchase credit assets such as US and emerging market corporate debt. CLO issuance climbed to $35 billion for the year at the end of May," Bloomberg reported, citing S&P Capital IQ/LCD. Note that despite the lower interest rate exposure, leveraged loans typically carry higher credit risk;
  • Covenant-light loans pay less for more risk;
  • The S&P's (INDEXSP:.INX) distress ratio fell to the lowest since May 2011, the 10th consecutive monthly drop;
  • Texas pension fund plans to increase junk credit exposure: "The $23 billion fund said it will increase its high yield credit allocation to $992 million by the end of this year, from $414 million currently. The exposure will increase to $1.792 billion by the end of 2014 and $2.192 billion by the end of 2015"; and
  • Last and most eye-popping were last week's Wall Street Journal article discussing the rebirth of synthetic CDOs, and an earlier Bloomberg article from March of this year.
These are just the data points I found looking at one publication over a mere five-day period; I suspect that if I dug a little deeper I would probably find dozens additional anecdotes. These headlines do not reflect the type of behavior and attitudes seen at the end of a credit cycle.

Why the demand for corporate credit is, and likely will continue to be, so frantic could be the subject of many more articles, but I could never make the argument nearly as well as Brian Reynolds does in these two video clips (see here and here). As I credited to him before, Brian, the Chief Market Strategist at Rosenblatt Securities, has taught me almost everything I know on this surreal dance between corporate bonds and equities.

And before you think I am some sort of Pollyanna-ish permabull (longtime Minyanville readers know I could not be further removed from that description) I will also leave it to Brian to tell you that when this bond orgy ends, the unwind will likely make the 2007-2008 crisis seem like a walk in the park.

But that is not today's story, and fighting that battle prematurely can be very costly. Trust me -- been there, done that.

Twitter: @FZucchi
No positions in stocks mentioned.
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