NEW YORK, Aug 24 (IFR) - While corporate bond coupons have been shrinking fast, they haven’t been able to keep pace with the precipitous decline of Treasury rates.
As a result, the difference between corporate and Treasury yields — a key measure of high-grade bond investment risk — is wider than it has been all year. Yet corporate bonds, with the exception of banks, aren’t that much riskier.
Witness the option adjusted spread (OAS) between Treasuries and corporate bonds in the Barclays investment grade corporate index: closing at 2.12% on Tuesday, it is wider than it has been in more than a year and a half (see chart). Last Friday it breached the 2.00% mark for the first time since December 3 2009, when it closed at 2.03%.
For a chart of the OAS for all corporates and financials, please see:
Yesterday’s close was about 76bp wider than this year’s low of 1.36%. Reached on April 11, the low close came on a day when Wal-Mart Stores (WMT.N) took home US$5bn in a four-part trade, including low coupon records, and the 10-year Treasury note finished with a 3.59% yield.
Yesterday, the benchmark note closed at 2.15%, tighter than April by a whopping 144bp.
All of this means that though corporate bond yields have been falling fast, they have not caught up to Treasury yields, which have been changing hands near record lows. Industrial corporations in general are not underperforming, however. Quite the contrary: conservative business strategies since the credit crisis and record amounts of balance sheet cash has made them prime targets for debt investors.
“Despite increased risk aversion and broader economic weakness, credit fundamentals look pretty strong,” said Shobhit Gupta, credit strategist at Barclays Capital.
The main offender pushing the Barclays index wider is the financial sector, which comprises about 35% of the constituent securities. Usually more volatile than the overall index — especially during the credit crisis — financials finished Tuesday with a 2.93% OAS. The spread is subdivided into 2.87% for intermediate maturity financial bonds and the widest subsector in the financial index, 3.23% for long-dated securities.
“The move is extreme for banks,” an analyst said. “They have widened more than 100bp since the beginning of July.”
Over the same period the entire corporate index, including financials, widened about 55bp. Industrial credits, including big consumer borrowers like Coke (KO.N) and Pepsi PEP.N, but excluding utilities and banks, gapped out only about 35bp in the period.
Since the credit crisis, the financial space has been the most volatile and had a wider spread than the index as a whole. What’s more, the difference between financials and the entire index is growing. On April 11, when the corporate index had its low close this year of 1.36%, the financial component finished the day at 1.61%, for a 25bp spread differential. However, yesterday, the difference between spreads was 81bp.
Treasury yields, for their part, haven’t been any less precarious. The benchmark 10-year Treasury yield has been all over the place this month, closing trading as high as 2.77% on August 1, and as low as 2.07% last Friday.
But the industrial space is not so immune. Airlines and home construction companies, two important economic indicators, are generally lagging other non-financials. In the index airlines account for only 19 bonds and US$8.5bn, Gupta said. Those credits are standout laggards, nonetheless.
Yields on financial names, mostly banks, are most responsible for making spreads fatter. The sector is getting trounced in equities and bonds. Not only is the European banking crisis weighing down US firms, but protracted uncertainty around Bank of America (BAC.N) this week, for example, is also an albatross.
Within the financial space, there are some exceptions. Look no further than yesterday’s new issue from John Deere Capital Corp (DE.N), which provides retail financing for new John Deere equipment.
Though not subject to the same market forces as the US banking system, it’s still a financial name and treated as such. However, it was able to print a US$500m, five-year trade yesterday with zero new-issue concession. The trade finished with a 1.85% coupon, not very far from the tightest coupon ever for the maturity, and priced to yield Treasuries plus 95bp.
Credit spreads won’t always be this wide, especially if Treasury yields continue to increase as they are today (with the 10-year up more than 10bp this afternoon). And rising yields will be better for spread and yield investors.
Persistently low Treasury yields have slowed down the recovery in spreads.
“What low yields have done is make the recovery not as swift as it would be if Treasury rates were at more reasonable levels,” Barclays’ Gupta said. “You need a little more stability and an increase in yield for spreads to tighten again.”
Nonetheless, the comparably wide spreads on financials make them generally attractive for investors.
“Financials, including banks, are getting to levels that are attractive but for the volatility,” he said.
This story has been corrected to change "billion pounds" throughout to "bp". This error was introduced when the story was posted to Reuters.com