Fed decision increases risk of loss in bond investments

NEW YORK, Sept 14 (IFR) - The Federal Reserve's decision to continue flooding markets with liquidity and to keep interest rates low until 2015 has increased the risk of capital losses on US credit investments, if Treasury yields should make a sudden upward move.

"The steady progression of unconventional policy decisions since 2008 is pushing investments into US credit markets," said Edward B. Marrinan, head of macro credit strategy and co-head of Americas strategy at RBS Securities.

"The asset class is vulnerable to a sudden backup in Treasury yields, which could lead to a deterioration in total returns."

The market got a glimpse in August of how bad it could be, when 10-year Treasury yields suddenly jumped to 1.84% from 1.47%. Investment-grade bond investors were staring at a full percentage point loss on total return in less than one month, Marrinan said.

Investors subsequently recouped their losses after Treasuries and corporate bond spreads rallied back, but the elevated level of interest-rate sensitivity risk was clearly on display.

In fact, the continued drop in yields in the primary US investment-grade and high-yield markets is becoming a worry. And the trend is unlikely to reverse, as long as investors seeking returns that are better than ultra low-yielding Treasuries continue to flood the market.

FED UP

Current conditions have been orchestrated by the Federal Reserve through its Operation Twist and quantitative easing bond buying programmes. The Fed is helping companies deleverage and repair balance sheets by giving them access to cheap debt but it is also forcing investment money into riskier assets.

The momentum is likely to remain strong with the Federal Reserve pledging this week to buy US$40bn of agency MBS debt per month starting Friday and add to purchases until the outlook for the labour market improved substantially.

There is already a noticeable decline in execution efficiency for high-quality investment-grade bond names. With all the current central bank action, investor appetite is shifting to riskier assets and the crowding-in effect into highly-rated investment-grade bonds is beginning to dissipate.

"The highly-rated investment-grade issuers who want to come to market should come now before the higher-beta/lower-rated names have more runway," said one banker.

For transactions that priced in the previous week inside a spread of 70bp over Treasuries, the average new issue concession was just north of 7bp. For everything that priced wider of 70bp, it was more like 3bp, he said.

Last week, several bonds that were rated in the Triple B area ended up being priced with new issue concessions that ranged between a negative 8bp to 27bp.

CLOs, auto receivables-backed ABS and commercial mortgage bond markets were all back in the reckoning this week which was one of the busiest this year.

Now the worry is that the Fed-inspired rally may be causing excessive risk-taking. Any change in the Fed's stance on rates could cause complete mayhem with bond investment returns.

Expectations are that 10-year Treasury yields will tick up to about 2.00%-2.25% from the current 1.70%-1.8% levels by mid-2013 if the US government comes up with a credible plan to tackle its fiscal deficit problems and the ECB succeeds in resolving the European crisis.

"If rates gradually move up, it would be a manageable event for corporate credit total returns. But, if Treasuries sold off in one violent move, then it would be more problematic," said a banker.

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