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Are corporate bonds contradicting treasuries?

A growing chorus of soothsayers interprets 10-year Treasury yields of about 4 percent as evidence the global economy is doomed. Oil at $50 a barrel will crimp growth. Recession is around the corner. The Federal Reserve will soon abandon its campaign to drive up U.S. interest rates.

So why are investors buying U.S. corporate bonds maturing in the next four years and euro-denominated corporate bonds of all maturities at yields just 40 basis points more than government debt, the lowest spread in at least five years?

Slower growth would mean reduced profits for companies. The weaker their earnings, the more difficulty they have meeting their interest payments and paying their debts. To compensate for the increased risk of corporate debt facing a recession, you'd expect yield premiums to rise. It's not happening.

According to indexes compiled by Credit Suisse Group, the 40- basis point premium available on the most actively traded U.S. corporate bonds maturing in one to four years is the lowest in the five years the index has been in existence, and less than half its average in that period. A basis point is 0.01 percentage point.

For corporate debt of all maturities, spreads are about 90 basis points, compared with a five-year average of 144 basis points. Among Eurobonds, the current 40 basis-point spread compares with a five-year average of 70 basis points and a high of about 130 basis points reached two years ago.

Waning Profit Growth

The risk premium available on corporate debt is shrinking even as profit growth decelerates. For companies in the U.S. Standard & Poor's 500 index, earnings probably grew 14 percent this quarter, after four quarters when growth surpassed 20 percent, according to analyst forecasts compiled by Thomson Financial.

In Europe, members of the Dow Jones Stoxx 600 will have profit growth of 21 percent this quarter, down from 27 percent in the previous three months, according to London-based research firm JCF Group. That's not bad -- it just isn't as good as it was.

Mark Kiesel, head of investment-grade corporate bonds at Pacific Investment Management Co. in Newport Beach, Calif., said in a recent commentary that "we are not being paid for this risk in corporate bonds today in most sectors.'' Pimco has about $400 billion in assets and runs the world's biggest bond fund.

Rescued by the Fed

"Corporate spreads are tight, and the slowdown in leverage and debt growth in the consumer sector will cause a pull back in consumer spending, threatening the economic recovery,'' Kiesel wrote. "We are going to return to a much slower rate of growth. When the Fed normalizes the short rate, we will look back on this time in history and say, in fact, that corporate profits weren't all that strong, that a significant portion of this profit growth and revenue growth was driven by low interest rates.''

For sure, credit spreads don't just track the outlook for earnings. An improvement in creditworthiness has also helped, as companies have stopped going bust. In August, not a single non-investment grade company rated by Moody's Investors Service defaulted, the first month that has happened since January 1998. Just 23 junk-rated borrowers have reneged on debt obligations worth $6.8 billion this year, compared with 65 companies failing to pay $31 billion in the same period last year.

Moreover, the credit derivatives market has a significant, if not fully quantifiable, influence on corporate bonds through collateralized debt obligations. Banks that package bonds or credit-default swaps to build CDOs create a new source of demand for corporate bonds, driving spreads down. The CDO buyers are mostly hedge funds, willing to take on the extra risk in complex, structured securities in anticipation of higher returns.

Hedge Funds Struggling

The CSFB-Tremont index of hedge fund returns shows that those funds have delivered just 2.75 percent this year, down from about 15.5 percent last year. Since April, they've lost about 0.5 percent. Disillusioned investors may start withdrawing cash from the hedge funds, sapping appetite for collateralized debt and knocking away one of the underpinnings for corporate bond spreads.

There's another worry for corporate bondholders. Given the dismal stock-market performance this year, with the major U.S. benchmarks all lower and anemic gains for most European and Asian equity markets, companies may rediscover the dreaded phrase "delivering shareholder value.'' That usually translates as handing over cash, in the form of share buybacks or higher dividends, to the detriment of bondholders.

Growth Forecasts

Of course, the recession and Fed pause that the Treasury market seems to herald might not happen. Maybe the oft-cited Treasury buying by Asian central banks, rather than the economic outlook, is the real driver of the 10-year yield.

Figures yesterday showed the U.S. economy grew 3.3 percent in the second quarter, better than the government's initial estimate for 2.8 percent growth and the 3 percent rate expected by economists in a Bloomberg survey.

Yesterday, the International Monetary Fund cut its 2005 growth forecast to 4.3 percent from an April projection of 4.4 percent, citing the surge in oil prices and higher borrowing costs. The Washington-based IMF said in its semi-annual World Economic Outlook that global growth will be 5 percent this year, better than the 4.6 percent it expected in April.

The bond market looks more and more dysfunctional. Treasuries are rallying even as the Fed tightens monetary conditions. Corporate-bond spreads are shrinking even as earnings estimates are pared. Lambs are lying down with lions. No good will come of it.


Gilbert is a columnist for Bloomberg News. Comments regarding this column can be sent to editor@sddt.com. All letters are forwarded to the author.

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