Corporate bond investors who scaled back their exposure in anticipation of a sell-off are growing impatient as they wonder if anything can slow down the long rally that began last October. The investors are looking for the market to dip as opportunity to get back in. Federated Investors went bullish on corporates about this time last year, but moved to a slight underweight some four to six weeks ago on the view that the rally would take a breather, and is now playing the wallflower as the party keeps rolling. "We had expected more issuance than we've seen. We thought the fear of rates rising would pressure issuers into bringing new supply," says Joe Balestrino, who manages some $8 billion for the Pittsburgh bond giant.
Last week's successful $3 billion two-part offering by Ford Motor Co. may induce other issuers to bring forth the long-awaited supply, but even that will not be enough to slow the market, argues a New York hedge fund investor. "It will take some unforeseen shock to really back spreads up meaningfully. It usually does happen every year in the fourth quarter, but you never know what it's going to be," he says. He is also net-short the market, waiting for such a shock, but is also growing impatient. "It's easier just to be long," he says.
At the end of last month, the option-adjusted spread (OAS) on the Lehman Brothers credit index was 109 basis points over Treasuries--tighter than it has been at the end of any month since April 1999. Through last Thursday, the OAS was still tighter--at 104. Since October 15 of last year, that spread-tightening has produced annualized returns of 12.65%--better than any calendar year since 1995. However, as spreads move tighter, the incentive for owning corporates diminishes because they yield only slightly more than Treasuries.
As a result of the tight spreads, Bear Stearns recently dropped its recommended corporate allocation to market-weight from moderate overweight. Simon Ballard, the firm's high-grade strategist, urges investors to take gains at the upper end of the credit ladder in particular. "People have had a fairly good year, and they'd probably prefer to keep their powder dry rather than risk any setback in the recovery story at this point," says Ballard.
But maintaining an overweight position has paid off for Fisher Francis Trees & Watts. Sai Choy, portfolio manager of $40 billion, says further tightening will induce him to sell low-beta names such as Wal-Mart, or perhaps high-quality utilities such as Southern Company Inc., Dominion Resources, or Keyspan Corp. If, contrary to his expectations, corporates do back up, he will add to riskier sectors such as paper and autos.