Investment-grade corporate bonds are the next “ugly bubble” as default rates soar and more than half of issuers face multiple ratings cuts, said Bob Janjuah, a credit strategist at Royal Bank of Scotland Group Plc.
Investors should be wary of buying investment-grade debt because defaults will “far exceed anything we have seen for 30 plus years,” Janjuah wrote in a note to clients. “And how would the IG corporate credit market fare if it knew that well over 50 percent of such issuers will see multiple ratings downgrades over the next 24 months?”
Companies have raised about 234 billion euros ($299 billion) selling bonds this year to investors lured by yields relative to government debt that are more than nine times levels on offer two years ago. Soaring issuance as defaults begin to rise from near-record lows have raised concerns a credit-market bubble is forming.
Standard & Poor’s said last week that 75 companies with rated debt of $174.5 billion are potential “fallen angels,” meaning investment-grade companies that may be downgraded to junk status. That’s the most in 18 years, according to S&P.
Junk, or speculative-grade, debt is rated below BBB- by S&P and Baa3 by Moody’s Investors Service.
“Major issuers” with ratings of AAA or AA, the top two categories, may be “seriously at risk of multiple downgrades,” Janjuah wrote.
CDX, ITraxx Surge
Derivatives will reflect the surge in defaults, Janjuah wrote. Credit-default swaps on the Markit CDX North America Investment-Grade index of 125 companies may exceed 250 this year, he said, the highest since December and up from 220 in New York today. An increase indicates a worsening outlook for credit quality. Contracts on the Markit iTraxx Europe index, currently at 185.5, may rise to 200 or more, he said.
Investors are “deluded” in thinking that the current crisis is confined to the U.S. and U.K. banking industries, according to Janjuah.
“Europe is in at least as big a mess,” he wrote. “There is simply a lag.” The result will be that the euro will “take up the ugliest currency baton” from the pound, which took it over from the dollar.
Emerging markets will suffer the most, and China will be a “major problem, not a major support,” Janjuah wrote. “Folks looking to China as a solution don’t get it.”
Spreads Widen
The extra yield investors demand to hold investment-grade company bonds in euros rather than government debt widened 0.16 percentage point this month to 4.22 percentage points, according to Merrill Lynch & Co.’s Investment-Grade Corporate Bond index. The spread has tripled in the past year, widening to a record 4.38 percentage points in December.
Investors should buy debt issued by the Group of Seven industrial economies, in particular euro government bonds, he said, predicting that yields on 10-year Gilts, Treasuries and German Bunds will be at or below 2 percent later this year.
Gilts currently yield 3.41 percent, Treasuries are at about 2.7 percent and Bunds yield about 2.97 percent.
Company bonds will probably “do OK or go sideways” for the next month or so, according to Janjuah.
“However this is a low-conviction call and one into which I would be selling risk,” he wrote. “The high-conviction call remains for a significant bear market in risk assets.”
RBS spokesman Steven Blaney in London wasn’t immediately able to comment on the report.
To contact the reporter on this story: John Glover in London atjohnglover@bloomberg.net
