Amid Corporate-Borrowing Bonanza, Some Money Managers Warn of Little Room Left for Gains
Amid the rush of bond deals, which already have topped $1 trillion in value, these managers—from BlackRock Inc. to Federated Investment Management Co.—are pointing to unusual wrinkles suggesting that now could be one of the most dangerous times in decades to lend to investment-grade companies.
Interest rates are so low and bond prices so high, they warn, that there is little room left for gains. Some worry that even a small increase in interest rates—a traditional enemy of bond returns—could eat away at bond prices.
For the first time in decades, some companies are offering a dividend yield—the value of annual dividend payments divided by the share price—that is higher than the interest rate they pay on their bonds, meaning that investors could get a better stream of income from stocks.
As a result, some of the largest investing houses—including BlackRock, the world's largest asset manager, and Federated—are looking for ways to reduce their exposure to U.S. corporate bonds. At Loomis Sayles & Co., a large bond manager, some money managers are moving into stocks and convertible bonds.
"Fixed-income is becoming an asset class with more risk to it, and I think people underestimate that," said Rick Rieder, who oversees more than $600 billion in assets as BlackRock 's chief investment officer of fundamental fixed income. He is making changes to minimize his exposure to potential losses from rising interest rates, including buying higher-yielding junk bonds and European debt. "It would take very little in the way of a rate increase for investors to lose their total returns across many traditional fixed income sectors."
For now, investors and companies are still rushing into the market.
Companies from General Electric Co. to Intel Corp. sold bonds this week, putting sales on pace to break the 2009 record of $1.024 trillion, according to data provider Dealogic.
The average double-A rated bond, the second-best grade given by credit-rating firms, yields 1.96%, compared with the average dividend of 2.33% for companies in the Standard & Poor's 500-stock index, according to Goldman Sachs Group Inc. Wal-Mart Stores, for instance, now pays a 2.22% dividend on its stock, up from 2.17% two years ago. Its bond maturing in 2020 yields 1.875%, from 4% two years ago.
Investors have been piling into bonds sold by investment-grade rated companies for the past few years, pouring a total of $976 billion into corporate-bond mutual funds since the end of 2008, according to Thomson Reuters unit Lipper.
These bonds were viewed as a sweet spot for many investors because they were considered less risky than stocks but also offered higher yields than U.S. Treasury bonds.
That drove prices up and yields down. High-grade corporate bonds have returned 10.13% so far this year, up from 8.15% last year, according to a Barclays PLC index. The demand prompted global companies to sell $3.65 trillion of debt in the past four years.
But the massive rally, which saw the average yield of an investment-grade corporate bond fall to 2.66% from 4.04%, means there is now little cushion should interest rates rise. As rates rise, the value of existing bonds with lower yields declines.
Yields are so low companies often borrow below the 2.2% inflation rate, meaning bondholders are losing money in real terms.
"This seems mathematically crazy," said Joe Balestrino, senior vice president for fixed-income at Federated in Pittsburgh. He owns fewer investment-grade corporate bonds than the benchmark index his fund tracks.
Bond math dictates that losses will be magnified when interest rates are low, and when bond maturities are long, as they are now. The average corporate bond sold in 2012 matured in more than 11 years, up from less than eight years in 2009, according to Dealogic.
According to Barclays data, if interest rates rose by just one percentage point, the average bond issued in 2012 would lose 5.12% of its value.
By contrast, the same scenario in 2007, when rates were higher and maturities shorter, would have caused a 1.82% decline.
And even if rates don't rise, the chances of a continued rally are slim, some skeptics say.
To generate capital appreciation, prices have to keep climbing, pushing yields lower. With average yields so low, another 10% annual return—the median average over the past three decades—would be "mathematically impossible" unless medium-term Treasury yields—the benchmark for corporate debt—fall to zero, according to Bank of America Merrill Lynch credit strategist Hans Mikkelson.
Some analysts and investors argue that interest rates are likely to remain low for some time. The Fed is still buying Treasury and mortgage bonds, keeping rates low, and has said it will keep overnight interest rates near zero through at least 2014.
"With Fed support, the demand for high-grade bonds will remain strong," said Eric Beinstein, credit strategist at J.P. Morgan Chase & Co. He projects a 5.4% total return in high-grade bonds next year.
Matt Eagan, co-portfolio manager at Loomis Sayles & Co., is looking for ways to avoid what he sees as a wall in bond prices. He increased the portion of stock holdings in his $14.6 billion Strategic Income Fund to 18%, the highest since its inception in 1995. Another 10% is in convertible bonds that can convert into stock.
"We haven't seen this situation where corporate bonds are out-yielded by their equities since the early 1970s," Mr. Eagan said. "As long as your time horizon is long enough and you can absorb some of the volatility, we think you have a better chance of preserving principal on the equity side."