Investors target beaten-down corporate bonds

LONDON (Reuters) - Investors are swooping in to buy corporate bonds beaten down so far that they are pricing in a severe depression and offer record premiums over credit derivatives and government debt.

European corporate bond spreads are trading at their widest level over government bonds in at least 20 years amid forced selling by hedge funds and expensive funding that has led new bond deals to price at significant premiums to outstanding debt.

"Warren Buffett was five years old when credit spreads were last at these levels," Jamie Stuttard, head of pan-European fixed income for Schroders, said in a presentation on Friday.

He referred to a graph showing the difference between U.S. investment-grade and government bond yields at around 600 basis points, a level last reached in the 1930s. "This is a market where it is almost more important to be a historian."

Bond prices have been hit as banks have aggressively reduced their inventories. Primary dealers have sold some $121 billion of corporate bonds from their balance sheets over the past year, according to Morgan Stanley credit strategists.

Also as leverage has become harder to get and hedge funds have been hit by redemptions, these players have retreated from the market, dumping bonds instead as they scramble for cash.

At the same time credit derivatives have rallied. The Markit iTraxx Europe index, made up of 125 investment-grade credits, is some 50 basis points below record wides of around 195 basis points hit two weeks ago.

"In the last few weeks, there has been a total breakdown between CDS markets and bond markets," said a trader.

LIQUIDITY PREMIUM

Andrea Cicione, a credit strategist at BNP Paribas, said: "Cash is more a story of a huge liquidity premium rather than an Armageddon scenario you would normally read in these kind of spread levels.

"Cash spreads are so wide that even if you take the worst possible case for the economy, spreads are totally unjustified."

European bonds are trading at about 141 basis points cheaper than CDS, said credit strategists at Barclays Capital.

Even so, they did not see outstanding value in bonds, because the cost for companies to raise funding has risen and that accounts for a large chunk of the difference in spreads.

Some investors, however, see the premium that companies must pay to sell debt in this market as an opportunity.

Schroders, which had around 19 billion pounds ($29.8 billion) in fixed income assets under management at the end of July, has started adding investment-grade bonds to its portfolio and particularly likes new issues, Stuttard said.

He cited Altria Group's sale this week of $6 billion in bonds, including five-year notes priced at 600 basis points over Treasuries.

That compared with spreads of 300 basis points over Treasuries for Altria bonds in the secondary market and credit default swaps at around 120 basis points, he said.

"The markets are extremely dislocated, providing excellent opportunities for the fixed income manager," he said.

But there are also huge risks and investors have to be selective, he cautioned. "We dislike about three-fourths of our universe in euros right now ... There are a lot of bonds that we are actively avoiding."

Another way to take advantage of the difference between bond and CDS spreads is through so-called "negative basis" trades, in which an investor buys a corporate bond and protection on that bond in the CDS market.

From the start the investor pockets the difference, known as "negative basis," by for example collecting 20 basis points between a bond spread of 100 basis points over midswaps and the cost of the CDS at 80 basis points.

"Effectively, this trade isolates all the credit risk in terms of defaults, and also in the meantime, the client takes the carry, which in this case would be around 20 basis points," the trader said.

(Editing by David Holmes)