Bonds Cap Epic Comeback

With Fed's Massive Mortgage-Buying Spree Ending Today, Market Seeks New Drivers

By MARK GONGLOFF

Investors flooded risky companies with money in March even as the government prepares to shut down a key engine driving one of the greatest corporate-bond rallies in history.
A total $31.5 billion in new high-yield debt, otherwise known as junk bonds, hit the market through Tuesday, exceeding the previous monthly record in November 2006. Partly propelling the activity: The Federal Reserve's massive mortgage-buying program, which comes to an end Wednesday.
By buying $1.25 trillion of mortgage securities, the Fed absorbed a flood of assets that otherwise would have needed buyers. That kept money in the hands of investors, who went searching for something else to buy. The Fed's underpinning encouraged investors to seek riskier, higher-yielding securities. A natural choice: corporate bonds.

The bond boom helped spur a rebound in the stock market and in the broader economy—recoveries that then, in turn, reinforced the bond rally. Investors poured a record $375.4 billion into bond mutual funds in 2009, while pulling out $8.7 billion from stock funds, according to data compiled by the Investment Company Institute.
Also on Tuesday, a closely watched index tracking high-yield bond returns reached an all-time peak, capping an 82% run from its December 2008 bottom, according to Bank of America Merrill Lynch indexes. Even returns on normally stodgy investment-grade U.S. debt are up 35% from their October 2008 bottom. By contrast, major stock-market indexes are still below precrisis levels, and their returns have trailed those of bonds.
Among the high-yield issuers in recent weeks have been California mortgage lender Provident Funding as well as Lyondell Chemical, which raised the money to help finance its emergence from bankruptcy-court protection.
Just 18 months ago, in the depth of the financial crisis—a time when the nation's debt markets were frozen—this kind of activity was all but unimaginable. Lehman Brothers had collapsed and investors sold bonds indiscriminately to meet their short-term cash needs, just to survive. Doubts were growing about the survivability of even some of the world's most credit-worthy companies.
Today, with the Fed's mortgage-buying program coming to an end, the debate is turning to whether the economy can sustain the rally. The odds are increasing that corporate-bond gains may be limited from here, given the heights already reached, the government's reduced support and the risk of rising interest rates.

Much of the focus concerns the strength of economic growth, with many investors arguing that further market gains depend on a "Goldilocks" scenario—with growth neither too strong nor too weak—to continue. "If we have an anemic recovery, then most of the market is overrated," says Joe Ramos, lead fixed-income portfolio manager at Lazard Asset Management. "Everything from municipal bonds to corporate debt is rated too highly for the level of cash flow that can be generated."
He defines anemic as a recovery with gross domestic product growth a good bit slower than the 3% economists expect for 2010, along with stubbornly high unemployment. A too-strong recovery, on the other hand, would raise interest rates and could push investors out of bonds and into stocks.
Bullish investors counter that stronger economic growth and a quick drop in unemployment would lower the risk of corporate defaults and make debt an even safer bet. "Yields are still low, and there is still an insatiable demand for higher yield," says Jim Sarni, senior portfolio manager at Payden & Rygel. "That is what will be the self-sustaining mechanism."
He and others also note that a lackluster recovery would keep the Fed from raising short-term interest rates, which also protects fixed-income investments.
The revival of bond fortunes has roots in the Fed's decision, around Thanksgiving 2008, that may have done more than anything else to encourage more investors to take a flyer on bonds. On Nov. 25, the Fed announced it planned to buy debt and mortgage-backed securities issued by housing-related government-sponsored entities such as Fannie Mae and Freddie Mac.
The program pushed mortgage-security prices higher, giving fixed-income money managers an incentive to sell to the Fed. In return, they had a flow of cash that had to be put to work. With Treasury debt yields at record lows, the best alternative remaining was corporate debt.
"That was the big turning point," says Ashish Shah, head of global credit strategy at Barclays Capital. "That's what drove money into credit."

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The Fed expanded this program on March 18, of last year, to buy $1.25 trillion in mortgage securities, along with $200 billion in debt of Fannie and Freddie and up to $300 billion in long-term Treasury debt. The expansion fueled the second leg of the credit rally, which hasn't stopped yet.
Fed officials wouldn't comment on whether they intended this secondary effect when designing their asset-purchase program. But they have suggested in speeches that it was a predictable outcome.
"With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities," Brian Sack, head of open-market operations at the New York Fed, said in a speech in early December last year.
The Fed added to the buying pressure in December 2008 by cutting its target for the federal-funds rate—an overnight bank-lending rate that affects other short-term borrowing costs throughout the economy—to roughly zero.
Thereafter, holding cash yielded nothing. And it cost next to nothing to borrow money to invest elsewhere.
"That was just a tremendous incentive to take on risk," says Kathleen Gaffney, co-manager of the Loomis Sayles Bond Fund. "When you looked at the yield on corporate credit, it was really too good to be true."
In fact, many investors struggled to find good bonds at bargain prices in the secondary market. So they vacuumed up any corporate bonds that were brought to market. In response, U.S. companies issued $122.9 billion in new debt in January 2009, a record pace for the month, according to Dealogic.
Given the unusual circumstances of the past couple of years, it is unlikely that the opportunities created by the Fed's program—giving investors the chance to make huge profits at the worst moments for credit—will come around again any time soon. "People always ask if the easy money has been made," said Jason Brady ,a fixed-income portfolio manager at Thornburg Investment Management in Santa Fe, N.M. "There was no easy money."
Write to Mark Gongloff at mark.gongloff@wsj.com