CORPORATE BONDS : NOT SO BRAVE IN THE NEW WORLD / THE WALL STREET JOURNAL

Heard on the Street

Corporate Bonds: Not So Brave in the New World

Divergence Between U.S. and Europe Markets Should Give Stock Investors Pause

By  Richard Barley

Nov. 23, 2014 1:46 p.m. ET

The bond-market sands are starting to shift.

That is particularly true in the U.S., where investment-grade corporate bonds, one of the long-standing beneficiaries of the financial crisis, have started to come under pressure. The gap between U.S. corporate bond yields and U.S. Treasurys now stands close to its widest this year, around 1.24 percentage points, according to Barclays indexes. Year-to-date returns have faded from above 8% in mid-October to closer to 6%.

That should give pause to investors in U.S. stocks, which have recovered from October’s turmoil to set highs for the year. It also poses questions about performance in Europe, where corporate bond spreads over haven government bonds are close to their tightest level for the year. Indeed, until late August, European and U.S. spreads had moved almost in lock step.

Companies are finding issuing new bonds in the U.S. a tougher proposition than just a few months ago. Issuance has been heavy, with mergers-and-acquisitions activity increasing bond supply.

Bankers report that investors are becoming pickier, and as a result borrowers that are less well-known or are raising relatively small amounts are having to pay up to attract orders. Issuers looking to sell long-dated bonds have had to pay higher new-issue premiums of about 0.2 percentage point above market yields, Royal Bank of Scotland strategists note.

The clearest explanation: shifts in monetary policy. The Federal Reserve has wound down its bond purchases, while the European Central Bank is only just starting to expand its balance sheet again.

European corporate bonds have benefited from speculation the ECB may buy paper in this market.

U.S. investment-grade bonds face stiffer competition for investor attention with the Fed no longer printing money.

The corporate bond market also is grappling with a fundamental threat to credit quality: The declining oil price threatens the U.S. energy sector. That is mostly playing out in the high-yield market, in which energy companies are the largest industry grouping at 16% of market value, Deutsche Bank notes. But it is also filtering through to the investment-grade market, in which low yields provide little cushion against credit deterioration.

These factors help explain the divergence between European and U.S. bond markets, something that is good news for the ECB. It would have a headache if higher U.S. yields drove up borrowing costs in Europe. The gap between U.S. and European bond markets can persist and even widen on that basis.

The divergence with stocks is trickier to figure out. Some of it is down to bond-market factors such as heavy supply. It also perhaps recognizes that companies in the U.S. are more focused on activity that tends not to be such good news for bondholders such as M&A or share buybacks.

Still, stock investors may find it tougher to keep their nerve if U.S. corporate bond yields start rising in earnest.