Low corp bond returns may add allure to stocks
NEW YORK, Dec 14 (IFR) - Returns in the corporate bond markets are expected to be so low next year - and the threat of rising interest rates so real - that some strategists say investors should start pulling money out of bonds and putting it into stocks.
Investment-grade bonds are expected to provide a mere 1.6% to 3% in returns in 2013, down from 9.6% this year and an average of around 12% every year since the credit crisis. Even high-yield returns will plunge to around 3%-7% in 2013, a drop from 15% this year and an annual average of 22% since the crisis.
Meanwhile the S&P is forecast to produce double-digit returns next year, after year-to-date returns of about 13.5%.
Investors have been pouring their money into investment-grade corporate bonds since 2009 in a bid to preserve their capital, a move that made sense as long as fixed income provided equity-like returns.
But with corporate bond yields now so low, dollar prices so high, and the prospect of Treasury rates inching up from rock-bottom levels, the bulk of the US investment-grade market is currently offering poor return prospects at best, and outright losses if rates rise more than expected.
"Rising long term interest rates represent the key risk for investment-grade credit in 2013," said Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch.
"Given ultra-low investment-grade yields of 2.75% to start, if 10-year Treasury yields increase to just 2.3% in 2013 - which appears not an outrageously high number - the return on investment-grade corporate bonds next year could turn negative."
Many fixed income portfolio managers lost interest in single-A and higher-rated industrial corporate bonds months ago.
"There is no doubt that if rates go up, there is no cushion for those bonds with mid double-digit credit spreads between 30bp-90bp over Treasuries," said Michael Collins, senior portfolio manager at Prudential.
"Total returns will be low single digits or negative for a big chunk of the investment-grade market if rates increase, and a lot of people believe that will be the case," he said.
GLORY DAYS OVER
Although there is still some faith in high-yield bonds, meanwhile, firms like Morgan Stanley are warning that "the days of equity-like returns with credit-like downside are in the rear-view mirror."
Fund managers like Scott Kimball, at Bank of Montreal's alpha-producing fund management firm Taplin, Canida & Habacht, think high-yield bonds as well as emerging market names are grossly over-valued and are taking profits.
And from a macro asset allocation perspective, Collins recommends reducing fixed-income exposure and increasing equities.
"I would recommend that for the same reasons that company treasurers are borrowing to buy back stock," said Collins.
"Many investment-grade companies have been borrowing at costs in the low single-digits and buying back stock that's paying a higher dividend than where they borrowed."
But whether investors will actually shift back into equities in the wake of the financial crisis is unclear.
"There's been a fundamental shift in the psyche of US investors since the credit crisis, where people have put their money in bonds to preserve their capital, rather than risk losing their savings in the stock market," said Krishna Memani, senior director and portfolio manager at OppenheimerFunds.
"But the driver of flows is not necessarily a desire to generate a lot of capital appreciation. I don't think that will change in 2013, and I expect money will continue to flow into investment-grade corporate bonds."
OppenheimerFunds is among a growing number of fund management firms recommending a reduction in corporate bonds - and an increase in stocks - in overall allocations.
Nonetheless, Oppenheimer acknowledges there are still investing clients that will continue to insist on investing in bonds.
"While we like to think that bonds have done well since 2009, equity has done a whole lot better," said Memani. "Despite that, investors want to stay in bonds. Our investment committee accepts that as a fact, but they think it is faulty thinking on the part of individuals."
BAML's Mikkelsen, however, expects that some investors will quickly change their tune when they realize they can no longer get equity-like returns in the bond market.
He says 2013 will be "a year of transition from the three-decade-long great bond bull market to a period of rising interest rates and the 'great rotation' out of bonds into equities."
"In the last several years it hasn't hurt investors to not be in stocks, but what's changing next year is that bond returns will be extremely poor," said Mikkelsen.
"In that environment a lot of investors will not be happy to be in bonds and will go into equity, despite not being completely comfortable with the risk."
If investors insist on staying in high-grade bonds, then they should focus on the financial institution group (FIG), which still trades about 21bp wider than industrials in the Barclays Investment Grade Corporate Bond index. FIG bonds have the potential to trade flat to through non-financial corporates in the year ahead.
There is also potential for spread tightening in industrial names in the triple-B corporate category, as long as investors have the wherewithal to dodge corporates' increasing debt simply to buy back shares or pay out special dividends.
"The crossover trade is also still compelling," said Collins. "The spread between triple and double-Bs at around 250bp is still wider than the historical average that's close to 200bp."
The only area Memani will play in the investment-grade market is in FIG. Instead he is focusing on high-yield, leveraged loans and emerging market bonds.
"We like the double Bs a lot, more than the triple Bs, because the level of credit risk you are taking from going down from triple B to double B is not as much as what the difference is between the two categories in terms of spread," he said.
The speed at which any rotation into equity occurs will depend very much on whether Treasury yields surge unexpectedly.
Morgan Stanley expects the 10-year yield to be around 2.25% by the end of next year, while Citigroup is expecting 2.5% by year-end. If Citi's correct, then that will mean negative total returns in a large swath of the investment-grade corporate market.
The Fed's decision to link its near-zero interest rate policy to unemployment staying above 6.5% in the US could increase Treasury volatility around payroll data time every month. Yields could spike if the numbers are good.
Yet Fed chairman Ben Bernanke has given himself huge wiggle room to talk a market back from the edge, say analysts.
Kimball argues that the bond and equity markets' fortunes are now so inter-dependent that any reallocation into equities will be tempered.
"I think the two markets have become linked more than people appreciate, so there can be a peaceful coexistence," he said.
"At some point there is going to be an expectation that fixed income has done so well for so long, that we will see a rotation into equities.
"But people also need to recognize - and this is what I think keeps fixed income alive in a low-return environment - that so much of what has been created in terms of equity valuations is linked to companies' ability to borrow at low rates to do share repurchases and pay special dividends," Kimball said.
"If that goes away because investors are moving out of bonds, then equity can also take a hit."
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