Outlook 2012: Bond spreads widen; banks cheaper; Europe to pressure weaker high-grade names

By Cristal Cody

Prospect News, Dec. 30 - Trading in the investment-grade bond market over the last half of 2011 was tougher as Europe weighed on markets, financials soured and Treasury yields hit record lows.

Future performance in 2012 is difficult for many to ballpark.

"There's not a lot of conviction out there," one trader said. "There's so much uncertainty, it's hard to make a call right now."

Much of the weakness in the last half of the year is attributed to market volatility from Europe, and Europe is blamed for the lack of a year-end rally in high-grade bonds, sources said.

"Everyone is sitting around on their hands waiting until the year ends and then try to pick things up next year," a trader said. "You keep thinking you're going to have a Santa Claus rally and a New Year's rally but you're sitting on the sidelines because of Europe and you don't want to take any risk."

Paper traded much more cheaply in 2011, and the high-grade market will be faced with "frustratingly low yields" in the New Year, a trader said.

The Markit CDX Series 17 North American investment-grade index widened to a spread of 122 basis points by late December from a spread of 83 bps at the start of 2011.

The 10-year benchmark Treasury note yield fell to the 1.95% area in late December from 3.33% in January 2011. The 30-year bond yield has dropped to 2.98% from 4.4% over the past year.

"We've already had an extended period of time with low yields, but I don't see that changing anytime soon," a source said.

Financials gap out

Bank and financial paper from Bank of America Corp., Morgan Stanley, Goldman Sachs Group, Inc. and General Electric Capital Corp. all gapped out over the year.

"There was a big sell-off in financials that started off in August and continued into October when Morgan Stanley, Bank of America, Goldman really got cheap," another trader said. "Looking back over the past year, there was a huge buying opportunities between August and October in those financial names."

Bank of America's bonds have widened nearly 300 basis points in trading over 2011.

The Charlotte, N.C.-based bank's 5% notes due 2021 were sold on May 10, 2011 at a spread of 185 bps over Treasuries.

The 10-year notes were quoted at 460 bps bid, 440 bps offered on Dec. 21.

"Now they're bouncing off their lows, so people are feeling a little bit better," a source said.

As Europe pressured financials and weaker-trading names that may have exposure to sovereign credit, that gave rise to higher demand for quality non-bank paper and short-dated debt, according to traders.

"Accounts are taking advantage of it, especially in short paper," one trader said. "All the short paper two years in is trading very well. There's such a big demand for short money."

In new investment-grade issues sold in 2011, Hewlett-Packard Co.'s $3 billion bond sale on Dec. 6 stood out for secondary traders. The Palo Alto, Calif.-based company's tranche of 10-year notes priced with a 20-bps difference from the company's 10-year note sale three months earlier.

"HP priced in September 4 3/8% 2021s at 240 [bps], and the price on the new ones is 260 [bps]," a trader said.

Stuck with low yields

Over the next couple of years, investors are expected to be pushed more into cheaper names including financial and BBB-rated industrial paper for higher yields.

"GE is a cheaper name than agencies or Treasuries," a retail trader said of the Fairfield, Conn.-based financing arm of General Electric Corp. "Almost everybody is changing their risk tolerance guidelines and accepting more risk in some shape or form than they used to. Some of them are reaching for yields in junk bonds.

"Ten-year notes that only yield 2%, they're almost being forced into more risk for greater return."

Investors are sitting on plenty of cash with everyone waiting for rates to go higher, sources said.

"We're stuck with low yields for investors for at least the near future," one bond source said.

Although investment-grade bonds ended the year weaker, the space should stay strong in 2012.

"From what I can tell, it looks like it's going to probably be pretty good on the investment-grade side with the caveat to stay away from companies and banks with large exposure to European debt," a high-grade trader said. "Corporations still have a ton of cash on their balance sheet. Earnings are decent. Investors still need some yield pickup over Treasuries, so tone will probably be pretty good."

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