By Dena Aubin
NEW YORK, April 30 (Reuters) - Signs that the 16-month U.S. recession may be easing are adding fuel to a rally in U.S. corporate bonds, creating a scramble for new issues and fresh waves of buying for the riskiest bonds.
Despite caution from some strategists that the optimism may be getting out of hand, investors are seeking out corporate bonds on a view that a massive sell-off last year has left the market too cheap, especially if the worst fears of a financial meltdown were overdone.
"In a fundamental sense, there is no near-term prospect of improvement in corporate earnings," said Martin Fridson, chief executive officer of Fridson Investment Advisors. "But investors are encouraged by the mere fact that economic indicators are declining less rapidly than they were a few months ago."
While risk appetite has been improving for months, the rally is now affecting the riskiest parts of the market as distressed debt buyers step in to snap up beaten-down bonds.
That strategy has its dangers. Not only do rating agencies expect the default rate to rise close to levels seen during the Great Depression, but some analysts expect the recovery rates that bondholders receive on defaulting bonds to match the lows seen in the 1980s.
RISKIEST BONDS UP 16 PCT
Yet bonds in the lowest rating categories, the CCC range, are up 15.8 percent month to date, while distressed bonds are up 14.1 percent according to Merrill Lynch.
Those gains have helped lift high-yield bonds overall to their best monthly performance on record, with total returns of 9.69 percent, according to Merrill Lynch data. The previous record for high-yield bonds, those rated below investment grade, was 8.68 percent in February 1991, according to Merrill Lynch.
Part of the rally stems from improved technical conditions, or a better balance of supply and demand after high-yield mutual funds attracted more than $4 billion in net inflows in recent weeks.
"The technicals are exaggerating the rally, but the key is going to be the economic data and the policy flow going forward," said Andrew Feltus, portfolio manager at Pioneer Investments in Boston.
Investment-grade corporate bonds have posted 2.67 percent total returns this month. In another sign of falling perceived risk, their yield spreads over Treasuries have dropped by 84 basis points this month to 502 basis points, the lowest since Oct. 3, according to Merrill.
The rally is creating a financing window for corporate borrowers and quick gains for investors. Yield spreads on some recent new issues have tightened by more than 100 basis points, with one deal, from Energy Transfer Partners LP (ETP.N), tightening 232 basis points since its April 2 pricing, according to IFR, a Thomson Reuters publication.
STRESS TESTS NEXT HURDLE
Corporate bonds are rebounding from a fierce sell-off last year, when panic about a potential financial system meltdown spurred selling of even higher-quality corporate debt.
"I don't think this rally is overshot, because I think it reflects a coming back from the brink of total panic, but to make much headway from here you are really counting on improving fundamentals," said Jay Mueller, senior portfolio manager with Wells Capital Management, Milwaukee, Wisconsin.
"The (economic) fundamentals are still bad and will probably get worse before they get better," Mueller said.
The U.S. recession is on track to become the longest since the Great Depression next month, though a few signs have surfaced that the pace of the slump is easing.
Strategists are also cautious ahead of the results of stress tests of the nation's largest banks, which could underscore how reliant banks would be on government support if the recession worsened.
"Markets are betting that we are not looking at a failed institution, that we are not looking at systemic failure any more, but that doesn't mean you aren't still looking at these headline risks which make for a step back," said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.
"Next week may be an opportunity to take a step back depending on the results of the stress tests."
(Reporting by John Parry, Tom Ryan and Dena Aubin; Editing by Diane Craft) (dena.aubin@thomsonreuters.com; +1-646-223-6325; Reuters Messaging: dena.aubin.reuters.com@reuters.net))
