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Bond investors are showing the most confidence in corporate America since the financial crisis, underscoring expectations that the U.S. economy will keep rolling as the Federal Reserve prepares to trim monetary stimulus.
Purchasers of corporate debt are demanding the smallest interest-rate premium to comparable government bonds since 2007. Demand has also put sales of new junk-rated corporate bonds in the U.S. on pace to surpass last year's record. Sales of investment-grade bonds in the U.S. this year are already at the highest ever, according to data provider Dealogic.
The trend shows bond buyers' increasing comfort that companies will repay them, thanks to rock-bottom interest rates and an economic recovery that, while tepid, is showing signs of renewed strength.
As well, companies are benefiting from investor demand for the income generated by corporate bonds, as yields offered by other debt such as U.S. Treasurys remain low. That demand helped Verizon Communications Inc. (VZ) complete a $49 billion bond sale in September, the largest corporate-bond sale on record, beating out Apple Inc.'s (AAPL) $17 billion deal in April.
High-grade corporate debt now yields 1.21 percentage points more than comparable U.S. Treasurys, while the gap, or spread, between junk-rated debt and Treasurys is 3.96 percentage points, according to Barclays indexes. Last year at this time, high-grade debt was yielding 1.45 percentage points more than Treasurys and junk debt was yielding 5.09 percentage points more.
"The fact that spreads are tight suggests that economic conditions should be good for the foreseeable future," said Anthony Valeri, fixed-income strategist at brokerage and investment firm LPL Financial.
Still, it hasn't all been smooth sailing for corporate-bond investors this year.
High-grade corporate bonds have lost 1.59% overall in 2013, largely because interest rates shot up over the summer after several years of near-double-digit returns. When rates rise, the prices of existing bonds fall. Junk bonds have fared better, returning a positive 7.01% this year.
Some investors say they are being cautious as they head into 2014.
"The last couple years have been easy," said Tom Murphy, who helps oversee $27 billion as head of investment-grade credit at Columbia Management. "Now we think you need to be a little more thoughtful about where your returns are going to come from."
Strategists say corporate debt is still likely to perform better than U.S. government bonds, even if interest rates rise as many expect. The higher yields on corporate debt are likely to provide a cushion against any rises in interest rates, they say.
They say bonds maturing in about seven years or less from highly rated companies could see positive returns next year even if rates rise. The shorter the maturity, the less sensitive a bond's price is to changes in interest rates.
Arne Espe, a portfolio manager at USAA Investments, says he has been buying corporate bonds with fixed interest rates that turn into floating rates if the borrower decides not to repay the debt early.
Earlier this year, he said he bought a bond from insurance company Lincoln National Corp. (LNC) that is due to mature in 2066. The debt, currently yielding 6.32%, converts to floating-rate in May 2016 if the company doesn't refinance the debt. Floating rates would be attractive given that overall interest rates are likely to rise by then, Mr. Espe said.
Mr. Espe also said his firm was favoring high-yield bonds from below-investment-grade companies over highly rated debt, because the high-yield bonds tend to do better in a rising-rate environment. For higher-grade bonds with regular fixed rates, he said his firm was focusing on debt with shorter maturities.
The narrowest reading for investment-grade corporate-bond spreads in recent years came in 2005, when the gap hit 0.75 percentage point. Corporate-bond prices plummeted when the downturn hit and the housing boom collapsed, triggering a global selloff of risky assets. Analysts don't expect any such reversal now.
"The housing crisis wasn't really appreciated then. Everybody thought everything was hunky-dory," said Tom DeMarco, market strategist at Fidelity Capital Markets. "Now you've got a much different economy and you've got this unconventional Fed policy involved."
Investors expect the Fed will start winding down that policy in the coming weeks or months. The Fed is buying $85 billion of bonds each month, helping keep bond yields low and buoying other asset prices, though it has signaled it will soon reduce that effort.
Demand for corporate debt helped triple-A-rated Johnson & Johnson (JNJ) sell $500 million in 30-year bonds earlier this month, offering a yield of 4.518%, or 0.65 percentage point more yield than comparable Treasurys. In 2011, Johnson & Johnson sold $300 million of 30-year debt at a 4.892% yield, or 0.68 percentage point more than comparable Treasurys at the time.
Dominic Caruso, the chief financial officer of Johnson & Johnson, said the company took the opportunity to refinance short-term debt and "replace it with longer-term debt at attractive rates."
The combination of a strengthening economy and high demand for corporate bonds have meant that defaults are increasingly rare, making the debt an even better deal for buyers. According to Moody's Investors Service, the default rate for below-investment-grade companies in the U.S. was 2.4% in November, down from 3.1% a year earlier.
Bob Michele, chief investment officer for global fixed income at J.P. Morgan Asset Management, said his firm has kept buying corporate bonds. Mr. Michele, whose firm oversees $365 billion in bonds, said he thinks spreads will continue to fall, offsetting any rate rise.
"We love corporate bonds," Mr. Michele said.
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