By Elizabeth Stanton and Shannon D. Harrington
Dec. 1 (Bloomberg) -- A rally in investment-grade corporate bonds may be at an end, according to Bill Gross, manager of the world's biggest bond fund.
Pacific Investment Management Co.'s chief investment officer said gains have been driven partly by demand for a new type of derivative promising returns that are unlikely to last. Company debt has climbed even as the economy slowed to a rate that can't sustain current profit and job growth, Gross wrote in a commentary posted on the Newport Beach, California-based firm's Web site yesterday.
Gross has said a jump in derivatives trading is distorting debt prices and recommends investors buy two-year Treasuries to profit from Federal Reserve interest rate cuts. The corporate bond market's situation is similar to when the Fed's target rate for overnight loans reached 1 percent in 2004 or when Japanese government 10-year yields reached a record low in 2003, he said.
``Where is the present day counterpart to where one could claim that prices could go no higher or risk spreads compress no further?'' Gross asked. ``We are beginning to find such evidence in the investment grade corporate bond market.''
The extra yield, or spread, investors demand to own investment-grade corporate bonds rather than U.S. Treasuries has narrowed to 93 basis points from the high in August of 98 basis points, Merrill Lynch & Co. index data show. The average spread was 1.23 percentage points over the past five years. Investment grade bonds are rated BBB- and higher at Standard & Poor's and Baa3 and above at Moody's Investors Service.
Pimco had a 2 percent stake in investment-grade debt as of September. Gross, whose Pimco Total Return Fund managed $98 billion as of Oct. 31, last month predicted that the Fed may cut its target rate, currently 5.25 percent, in the first half.
CPDO Growth
Banks are creating so-called constant proportion debt obligations that have top AAA ratings and allow investors to leverage their investments 15 times with debt to generate returns of 2 percentage points over the London interbank offer rate, according to Gross.
With a $100 million initial investment, for example, the CPDO would invest in as much as $1.5 billion in U.S. and European indexes of credit-default swaps, financial instruments based on bonds and loans that are used to speculate on a company's ability to pay debt.
Since Dutch bank ABN Amro Holding NV sold the first CPDO in August, 1 billion to 2 billion euros ($1.32 billion to $2.65 billion) have been sold, according to Barclays Capital Inc.
Narrow Spreads
Credit-default swap spreads have narrowed so much since the creation of the investments that a few more basis points of tightening would wipe out the returns that made them attractive and jeopardize their high ratings, Gross said.
The Dow Jones CDX North America Investment Grade Index has fallen 18 percent to 33.92, from 41.12 on Sept. 22, according to data compiled by Credit Market Analysis. The level of the index, which is made up of credit-default swaps for 125 investment-grade U.S. and Canadian companies, means it costs an average of $33,920 a year to protect $10 million of bonds for five years.
The ITraxx Europe index of 125 investment-grade companies is down 18 percent to 24.98, from 30.62 on Sept. 22.
Default Protection
CPDOs also can't make greater use of leverage without imperiling their AAA ratings, Gross wrote. An analysis by Pimco concluded that there is a maximum amount of leveraged, seven to eight times in this case, beyond which returns can be maintained only with ``increasing and significant expectations of financial loss,'' he said.
``The increasing use of leverage, at least as applied to this particular area, appears to have run out of its magical ability to increase returns,'' Gross wrote. ``Investment-grade corporate spreads therefore are not likely to narrow further.''
Sales of CPDOs may slow because as tighter spreads make it more difficult for banks to construct deals that can generate the same high returns as the initial CPDOs, Alexandre Linden, a London-based director with Fitch Ratings, said in an interview last month.
Credit-default swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates. A basis point is 0.01 percentage point.
To contact the reporter on this story: Elizabeth Stanton in New York at estanton@bloomberg.net Shannon D. Harrington in New York at sharrington6@bloomberg.net
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