Forget bad news, the rush for bonds continues

Aug 17 (IFR) - Investors are expecting that volatility will return to plague the US corporate bond markets in the coming months, but it will take more than disappointing eurozone news, a looming US fiscal cliff and weaker global growth to stop them from buying bonds.

Overwhelmed by a wall of cash flowing into their portfolios, investors say they have to keep buying new bond issues, even in the face of bad news.

And rather than just staying defensive by buying higher-rated bonds and increasing cash positions, record low yields in both the junk and investment-grade spaces will continue to force investors down the credit-rating spectrum.

"I would actually welcome some volatility in the high-yield market," said Michael Collins, senior investment officer at Prudential.

"I am hard pressed to really envision a big sell-off, because any widening of spreads will bring in buyers."

POURING IN

More than US$39.2bn of new inflows have poured into the investment-grade market so far in 2012, with more than US$20bn into high-yield.

In the last 11 weeks alone, high-yield has been deluged with about US$9.4bn of new cash, driving down the Barclays high-yield index to a yearly low of 6.615%, just a hair's breadth away from its all-time low of 6.614% hit in May last year.

Investment-grade yields have meanwhile jumped to over 3% on the Barclays investment-grade corporate index in the past week, as a result of widening Treasury rates, but that's barely above the index's alltime low 2.92% yield hit in July.

It would take a protracted sell-off in Treasury rates to stop the flow of funds into fixed-income and put investors in a position where they don't feel that they have to buy everything that comes their way.

Investment-grade bonds are more vulnerable to outflows in a continued rising-rate environment, because they offer very little in the way of credit spread to offset the price losses arising from a widening of the Treasury rate portion of a corporate-bond yield.

For the moment, however, the back-up in Treasury rates in recent weeks hasn't made a dent in the level of inflows.

"The risk-on trade is not going to run out of steam until the flows stop coming into the market," said Bonnie Baha, a senior portfolio manager at DoubleLine Capital. "As long as the flows keep going, the risk-on trade will probably do reasonably well."

TECHNICALLY, THEY'RE GOOD

The extraordinarily strong technicals have fueled a record US$57.2bn of high-yield bond issuance in July and August, and pushed coupons below the 5% level for some double-B rated borrowers.

A record US$71.875bn of investment-grade bonds was priced in July, and issuance for August as of Thursday was just shy of US$50bn.

"September will be another blockbuster," said a senior investment-grade syndicate manager at one of the top underwriting firms. Investors are seeing bad eurozone and economic headlines on the horizon, forcing issuers to offer more in new-issue concession.

If rates continue their upward trajectory, the focus will be on shorter-dated new issues in both the high-grade and high-yield markets.

In the secondary markets, meanwhile, many investors will be avoiding the highest rating categories in their respective asset classes.

"You have to have a return on capital if you want to perform well," said Joel Levington a managing director who focuses on investment-grade bonds at Brookfield Investment Management. "And for a lot of single A and above paper, the return is so marginal, you really have to have a very strong case to be a buyer."

Double B-rated corporates in the high-yield market have also reached such tight levels that investors are now trawling the triple-C area for returns. The Barclays BB index has hit a record low of 5.22% in recent weeks. About 40% of the bonds in its high-yield index now trade above their call prices, making a "dash for trash" all the more likely.

That call constraint, however, isn't likely to slow the demand for single-B and above rated bonds in the new-issue market.

"Clearly a lot of high-yield is fully valued," said James Lee at Calvert Investments. "That being said, people give us money to put it to work. To some extent, even if you've got a skeptical eye, you can't sit there with 20% in cash."

LACK OF OPTIONS

The disappearance of supply in other higher yielding fixed-income asset classes is adding to demand.

"We are still trying to add exposure to US financials and high-yield to replace the structured product that is going away," said Prudential's Collins. "ABS has declined significantly as a percentage of the fixed-income markets, and isn't being replaced quickly enough by other sectors."

Some strategists suggest that investors should temper their quest down the ratings ladder if they expect volatility to increase.

"If I expected volatility to increase in September and the fourth quarter, then I would not be buying triple Cs, I would be getting more conservative and overweighting single Bs," said Brad Rogoff, head of credit strategy for Barclays.

That said, he added, "if the volatility doesn't rear its head in September, then at some point people will have to capitulate and buy triple Cs that have trailed in the most recent leg of the rally."

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