Anticipating Weakness in the Corporate Bond Market
December 10th, 2014 7:36 pmVia WSJ:
Bond Investors Look to Cull the Herd
Fund Managers Expect Bull Market to Weaken, Forcing Them to Identify Debt That Is Likely to Underperform
After years of strong gains and buying record amounts of debt, corporate-bond investors are facing a new challenge: what to sell.
Many fund managers expect the long bull market in bonds to weaken next year because of slowing economic growth overseas, plummeting oil prices and a potential increase in interest rates in the U.S.
That is forcing investors to identify bonds that are likely to lag behind the market, a task that stands to be more complicated than in past years, when widespread gains meant investors didn’t have to make as many hard choices on what to buy and sell.
Corporate debt in 2015 will be a bond picker’s market, said Jon Curran, a Boston-based portfolio manager and analyst at U.K.-based Standard Life Investments , which oversees $422 billion in assets.
The healthy gains seen in corporate bonds since the financial crisis could be more limited in coming years. Corporate executives are now beginning to take more risks to expand businesses as the U.S. economy improves, moves that could be detrimental to existing bondholders. Mergers and acquisitions are at the highest level in years, forcing some companies to offer generous yields on new debt sales.
Among the bonds being considered for disposal by some investors: debt from firms with heavy exposure to oil and energy, companies that appear to be struggling and have looming debt payments in coming years, or those that are considering taking on more debt for major acquisitions or share buybacks. Some investors said they are cautious about bonds that mature in the next few years because prices on that debt are expected to take a bigger hit than longer-dated bonds if the Federal Reserve raises short-term interest rates. Investors expect the Fed to raise rates as early as the middle of next year.
Scott Minerd, global chief investment officer at Guggenheim Partners, which manages more than $220 billion, said the firm is reviewing its bondholdings to assess the impact on companies if oil dropped to $25 a barrel. Oil is trading near $60 a barrel, sliding from more than $100 in June.
Standard Life’s Mr. Curran said he plans to steer clear of companies with low stock prices and low levels of debt, arguing that those conditions could entice management to pursue debt-financed stock buybacks or acquisitions. Companies pursuing those strategies tend to focus more on their share prices, many times at the expense of bond prices.
“Bondholders and shareholders are oftentimes just looking for different things,” Mr. Curran said.
Still, the worries highlight a potential change from the broad gains that dominated the years following the financial crisis. Prices of highly rated corporate debt in the U.S. have risen in four of the past five years and are on track for another gain this year, according to Barclays PLC data. And this year marked another record for U.S. corporate bond sales. So far in 2014, both investment-grade and junk-rated companies sold a little more than $1.5 trillion in the U.S. market, according to data provider Dealogic, eclipsing the previous record of $1.47 trillion set for all of last year.
But the performance of certain types of bonds has varied widely. Bonds from junk-rated energy companies, such as Chesapeake Energy Corp. and AmeriGas Partners LP, have lost 7.7% in total return this year, a figure that reflects interest payments and price changes, according to Barclays data. But bonds from junk-rated communications firms, including Charter Communications Inc. and CenturyLink Inc., are up 4.7%. Broadly, junk-rated corporate bonds are up 2.1%.
Highly rated corporate bonds are faring better, up 7%. But investors caution that much of that performance comes from Treasurys, which serve as a benchmark for high-grade corporate bonds. Treasurys have rallied this year, attracting overseas buyers given that yields are lower in other developed countries, with the 10-year note going from 3% at the end of 2013 to about 2.2% now, as bond yields move inversely to prices. If the Fed raises rates next year, that would increase Treasury yields and lower bond prices overall.
Others are more broadly optimistic about corporate bonds. Analysts at Morgan Stanley said they expect U.S. high-grade corporate bonds next year to return 3.1 percentage points more than comparable Treasurys, a figure they said is “significantly more than historical averages.”
Moreover, some bond investors are still willing to bet big on companies that have bright outlooks.
Medtronic Inc. sold $17 billion in debt this month, the largest corporate-bond sale of the year and tied for the second-largest ever. Amazon.com Inc. raised $6 billion, twice the size of its previous sale two years ago, amid projections for continued gains in the online-retail sector. Walgreen Co. in November sold $8 billion to help pay for its acquisition of European drugstore chain Alliance Boots GmbH.
Jim Dadura, a portfolio manager at investment firm Segall Bryant & Hamill, which oversees about $9.5 billion, said his firm bought about $35 million of Walgreen’s previously outstanding bond that matures in 2022, which dropped in price around the time of the merger announcement. Mr. Dadura said he thinks the bond will rally in coming years, given that Walgreen’s business is strong and now that the company successfully completed its large bond sale.
“Some of the uncertainty regarding the deal has dissipated,” Mr. Dadura said. “There’s been more clarity.”
Other investors are seeking out firms whose debt is offering more yield than rivals. Advent Capital Management, which oversees about $8 billion, owns bonds of Synovus Financial Corp. , a financial-services company and community bank. A Synovus bond maturing in 2019 recently traded with a yield of 4.445%. In comparison, a 2019 bond from BB&T Corp. , a larger and more highly rated company, recently traded to yield 2.059%.
If Synovus were to be acquired, it would likely be by a higher-rated competitor, boosting prices on Synovus’s existing bonds, said Doug Teresko, a portfolio manager at Advent. If it isn’t acquired, the company’s finances are still strengthening. It was recently upgraded by Moody’s Investors Service.
“We’re comfortable owning the position because we think it’s an improving credit,” Mr. Teresko said.