Doublethink Spells Trouble for Credit

By RICHARD BARLEY Credit markets are suffering from cognitive dissonance -- the uncomfortable feeling of holding two contradictory beliefs simultaneously. On one hand, investors fear fabled green shoots will turn out to be killer weeds. On the other, they see a "wall of money," much of it from retail investors, driving up prices, and don't want to be left behind. Perception is at odds with position -- a recipe for renewed market instability. This is clear from recent investor surveys. European credit investors held record long positions in May, while also seeing high inflows, according to Citigroup and J.P. Morgan. Yet 60% of investors plan to reduce exposure or hold steady -- even as more than half expect to have more money to manage, according to J.P. Morgan. Investor holdings are still concentrated in safer sectors such as telecommunications and utilities, and cash positions are way above average. But new issuance is coming increasingly from companies with low credit ratings and in cyclical sectors like steel. Wide spreads on such offerings are attracting less risk-averse investors. Meanwhile, conservative investors are missing out on the market rally. Further evidence of this dissonance comes from credit default swaps, where spreads have widened even as cash bond spreads have continued tightening and demand for new issues has remained strong. The CDX North American Investment Grade index has widened by 0.15 percentage point from its lows, while Merrill Lynch's corporate master bond index has tightened about 0.20 percentage point over the same period. How will this conflict be resolved? Much depends on retail investors, who are still piling into the market. In the U.K., sterling corporate bond funds have been the top destination for retail investors every month since November, according to the Investment Management Association. In the U.S., bond-fund inflows year-to-date added 6.5% to assets under management, TrimTabs Investment Research data show. Allocations of new euro bond issues to retail buyers have jumped to 20% this year from 3% last year, according to Société Générale. They are even leaping back into the bank capital market: Standard Chartered's $1.5 billion Tier 1 deal, sold largely to Asian retail investors, was six times oversubscribed this week. What isn't clear is whether retail investors are a leading or a lagging indicator: Does their arrival signal the rally has further to run, or is it time for the smart money to exit? For now, the technical factor of inflows trumps fundamental concerns over credit quality and the economy. But that could change if corporate bond yields rise -- either due to another shock or because underlying government bond yields climb -- and retail investors suffer. At that point the balance of power could change, and bearish institutional investors may find their fears justified. Write to Richard Barley at richard.barley@dowjones.com