If stocks drop, corporate bonds may feel the heat

Monday, October 5, 2009 Fri Oct 2, 2009 3:20pm EDT

John Parry, Judith Stein, and Biodun Iginla for the BBC

- Analysis

NEW YORK - If U.S. stocks were to enter another bear market amid fears of a second recession, this year's spectacular corporate bond market rally is in danger of reversing.

Yield-seeking investors who have poured money into corporate bonds this year are staying put for now but the market could be bruised if risk aversion rises sharply, analysts expect.

Over the past 10 days, investors have become increasingly jittery about how strong and sustainable the economic recovery will be; a prospect that has pulled U.S. stocks down about 4 percent from 11-month highs, accompanied by a pullback in corporate bond prices.

So far, the sell-offs have been modest, but increasingly economists warn that when the impact of massive government and Federal Reserve stimulus measures starts to fade in 2010, that persistent deflation and even a second recession could ensue.

Should these fears trigger another bear market in stocks, veteran corporate bond watchers warn junk bonds would become vulnerable to a selloff and even higher grade corporate debt may not withstand investors' rush back to safe-haven assets.

For the moment investors are thinking "high yield might be a good place to park some money while I wait for stock markets to get better," said longtime junk bond expert Martin Fridson, CEO of Fridson Investment Advisors in New York, at the Reuters Restructuring Summit this week.

Since reaching an 11-month closing high of 1,071 on September 22, the U.S. S&P 500 stock index .SPX has fallen some 4.3 percent. The same day, a 10-month rally in corporate bonds stalled, when yield spreads of investment grade corporates had narrowed to 230 basis points over Treasuries from record wides of 656 basis points in December at the height of the global financial market panic. Corporate bonds have since sold off modestly, with spreads widening to 238 basis points by Thursday, according to Bank of America Merrill Lynch data.

The Bank of America Merrill Lynch High Yield Master II Index of junk bonds has also sold off, with yield spreads over Treasuries widening to 811 basis points on Thursday from 787 basis points on September 24.

To be sure, if U.S. equity markets pull back moderately and the economy doesn't deteriorate dramatically, corporate bonds could still be viewed as a defensive bet and weather those circumstances well, bond strategists say.

"Historically a selloff in the stock market of up to about 10 percent has been neutral or even a positive factor for high yield because as investors become disenchanted with stocks they look at fixed income," still viewing corporate bonds as a fairly stable asset in an anemic economy, Fridson said.

But Fridson and other bond analysts say the ferocious junk bond market rally may have overshot.

U.S. high yield bond spreads over comparatively safe Treasuries have narrowed dramatically from wides of more than 2,100 basis points in December to just over 800 basis points now. Junk bonds have delivered a record 48 percent in total returns year-to-date. As retail investors have thrown money at lower-rated corporate debt almost indiscriminately, some fund managers have taken profits over the past two months.

"Spreads are back to their historical averages. Maybe the easy money has been made," said Jamie Cox, managing partner at financial planning and asset management company Harris Financial Group in Colonial Heights, Virginia.

Some fund managers even believe junk bonds could rally a bit more if the economy sidesteps the obstacles of high unemployment and cash-strapped consumers.

"A no-inflation, stagnation scenario in which things muddle along ... is probably good for corporate debt and probably OK for high yield, because even with the rally, spreads are still relatively wide," said Lawrence Glazer, managing partner of Mayflower Advisors in Boston. Continued...

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