Citi: Bonds Priced for Great Depression Defaults

LONDON (Reuters) – Prices of investment-grade bonds have fallen so far that their spreads already compensate for default rates worse than the Great Depression, Citigroup analysts said.

Bond spreads are a measure of the difference in yields between a given bond and a benchmark such as a Treasury bond. The wider the spread, the more risky the underlying bond.

“This is not to say that spreads in the near term may not go wider still,” they wrote in a recent note to investors. “Indeed, many investors are concerned that a vicious and self-reinforcing circle of forced unwinding and redemptions has already set in and now implies just that.”

But some investors “can already start to buy in, confident that on a buy-and-hold basis at these valuations, they should be able to absorb almost whatever the economy throws at them,” London-based analysts Tejas Shah, Michael Hampden-Turner and Matt King wrote.

Buy-and-hold investors, not hedge funds and private equity, are those best positioned to take advantage of cheap prices, because they do not rely on leverage and are not vulnerable to redemptions.

Citigroup compared current spreads of U.S. investment-grade bonds, high-yield bonds, credit default swaps and leveraged loans with “rock bottom” corporate spreads, which they calculated using a methodology developed at JPMorgan in 2001.

The rock-bottom spread takes into account the level that an investor needs to break even in a certain default scenario plus a reasonable return for the risk the investor is running.

The analysts calculated rock-bottom spread levels for the 1999-2003 bear market and the 1931-1935 Depression, assuming recovery rates of 20 percent.

They found that investment-grade bond spreads are currently wide compared with the 1930s scenario in every rating category. Spreads on five-year double-A bonds at 117 basis points outstripped the 67 basis points needed for 1931-1935, and on the lowest BBB- bonds at 724 basis points versus 472 basis points.

Financial bond spreads are even wider at 534 basis points for double-A and 1,493 basis points for BBB-.

Credit default swaps (CDS) on investment-grade borrowers are not as cheap as cash bonds, but spreads are still generally in line with 1930s levels.

HIGH-YIELD NOT

By contrast, high-yield bond pricing is less generous. Spreads for most ratings below BB+ are equal or higher than rock-bottom spreads for 1999-2003 but do not reach 1930s levels.

And CDS spreads on high-yield borrowers “would barely compensate for 1999-2003, let alone the 1930s”, the analysts found.

“Investment-grade, and indeed high-quality assets generally, have suffered disproportionately because they were more likely to be funded with leverage, which is no longer available,” the Citigroup report said.

“Private equity and hedge funds are often more prepared to invest in high-yielding assets these days, where they can achieve their target absolute returns with no or minimal leverage,” they wrote.

Citigroup made separate calculations for leveraged loans, using the same scenarios but factoring in typically higher recovery rates of 50 percent.

For loans, “spreads comfortably price in a nasty recession, and indeed are almost consistent with the 1931-1935 scenario, despite being less extreme than investment-grade bonds,” they said.

(Reporting by Jane Baird, editing by Will Waterman)