Top-rated industrial bonds losing their luster

Aug 27 (IFR) - Industrials rated single A and above, long considered the safest members of the investment-grade corporate bond market, are now looking like the riskiest, at least when it comes to spread performance.

In a market obsessed with yield, investors have noted with some bitterness that many non-financial borrowers rated single A or above are pushing underwriters so aggressively, in order to get them the tightest new issue spread, that some of their deals are underperforming.

"Look at Illinois Tool Works last week," said one investor, referring to a US$1.1bn 3.9% 30-year offering by the A1/A plus rated manufacturer of products like industrial packaging and power systems.

"They whispered (price guidance) at 125bp and priced at 105bp. They were wider by a few basis points when they were free to trade, because their underwriters took 20bp away for a name that did not have a lot of spread to begin with."

Although a few basis points of widening is hardly disastrous, it's a stark contrast to the performance of some other deals that offered incremental yield, and they're mostly in the financial institution group (FIG) sector or rated below single A.

Triple B minus Fidelity National Financial, a mortgage title insurer, came to market on the same day as Illinois Tool, with a US$400m 5.5% 10-year, whispered at 400bp area and priced at 375bp. It was 15bp tighter later in the week.

The differing fortunes of those deals in the aftermarket is also a clear indication of where value lies, at a time when spreads on everything, including FIG, are trading at year-to-date tights.

"Never say never, but I would expect to find little if anything in that (single A and above industrial) category with value," said Howard Greene, a senior portfolio manager with John Hancock Asset Management, the global asset management arm of Manulife Financial.

Bank of America Merrill Lynch credit strategists are still looking for about a 9-10bp spread tightening of their high grade index option adjusted spread to around 175bp before the year's out, but they believe almost all of that will come from the financial sector and triple Bs.

"We see little value in the single A and above rated industrial corporate sector between now and the end of the year, because their spreads are so very tight," said Yuriy Shchuchinov, credit strategist at BofA Merrill.

ALWAYS WANTED

Single A and above industrials will always be sought after, and will likely remain tight in spread, given the wall of cash flowing out of Treasuries and into blue chip corporates.

But unless they start to offer more new issue concession, there's more risk that these spreads will widen rather than tighten in today's market.

"These companies' spreads have little to no upside, but some downside risk if they decide to do M&A or share buybacks and fund it with debt," said Shchuchinov. "These are especially attractive strategies for these companies right now because they can issue debt at record low cost."

An example was Single A minus rated Aetna, whose bonds maturing in 2042 widened out about 10-20bp early last week after the health insurer announced its acquisition of Coventry Health Care.

Shchuchinov also noted that, unlike the triple B companies and the financials, the Single A and above rated industrials do not benefit from spread tightening derived from the general search for yield.

The fact that Single A and above industrials are in such demand is more due to the traditional view that these credits must be better because they're rated higher, and not because they are expected to perform better over time, said Joel Levington, managing director at Brookfield Investment Management.

"There's still a very strong demand for A and above industrials, and that goes to the point that many investment committees haven't gotten rid of the idea of being overweight this sector," said Levington.

"I think if you want to go after the best portfolio of credits that can give you the best risk-adjusted return, you should certain review that thought very carefully."

When it comes to adding to his portfolio, Greene, like many other total return investors, is focusing on the three "high-beta babies" -- financials, high yield-bonds and mortgages (which includes both commercial and non-agency residential mortgage-backed securities).

While spreads on the higher beta names can underperform the rest of the market in uncertain times, they tend to outperform when the outlook improves. Financials, for instance, have significantly outperformed single-A and above industrial spreads this year, and are expected to continue doing so, now that the tail-risk of a eurozone collapse is suddenly put back on the table.

Greene is the lead portfolio manager for the John Hancock Bond Fund, which has about 50% in corporate bonds. Of that, about 20% is high-yield and about 20-30% in high grade, but the bulk of that high-grade exposure is in financials. About 8-9% of the overall portfolio is in CMBS, with a slightly smaller exposure to various non-agency RMBS.

The razor-thin credit spreads on single-A and above industrials also makes their overall yield and price changes very highly correlated to any move higher in Treasury yields.

"The riskiest market at the moment is Treasuries," said Greene. "We have a good portion of high-yield bonds, financials, CMBS, adjustable rate mortgage securities and some levered loans, so if rates start to rise we are pretty well insulated."

"I don't think we will see a massive rate hike, but the shock is in the speed of the move," Greene added. "Treasury yields can jump 50-70bp within a matter of weeks, and that would not be a pretty sight if your biggest exposures were in Treasuries and tightly trading single A and above rated industrials."

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