Wall Street's biggest bond dealers are finding less and less to like about top-rated U.S. corporate bonds.
So much so that they're betting against some of them, with primary dealers last week turning the most bearish of 2015 on debt maturing in five to 10 years, Federal Reserve data show. The detail on banks' more-granular positions only covers January and February because the Fed just started reporting it.
In any event, it appears the fervent flight to the safety of high-quality corporate debt is coming to an abrupt end. The bonds have declined 1.3 percent in February, poised for their worst monthly decline since the taper tantrum of 2013, according to Bank of America Merrill Lynch index data. That's a reversal of January, when the debt gained 2.7 percent in its best start to a year since 1988.
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What's changed? Rather than a referendum on the health of Corporate America, this may have to do more with benchmark government yields, which have risen this month as the U.S. economy shows signs of improvement. This eats into the value of investment-grade debt that's pegged to these yields.
"We may find that the recent low Treasury rates could prove to be all too temporary," International Monetary Fund analysts Nigel Chalk and Jarkko Turunen wrote in a Feb. 12 website post. "We may look back on this time with hindsight as a period where long-term rates transitorily overshot their fundamentals."
Investment-grade bonds may be among the bigger casualties of a sudden shift higher in rates. The debt is about as vulnerable to moves in U.S. borrowing costs as it's ever been, based on a measure of interest-rate sensitivity as calculated by Bank of America Merrill Lynch index data.
Investors are accepting 1.43 percentage points in extra yield over benchmark rates, compared with as high as 6.56 percentage points at the height of the 2008 financial crisis.
Of course, analysts have been predicting higher Treasury yields for a while now, only to watch them fall. That could very well happen again given the tremendous demand globally for safe debt that yields anything at all.
Yet there are signs that some of the enthusiasm for high-grade corporates is starting to wane. The 22 primary dealers that trade directly with the Fed have a short position of $826 million betting against investment-grade bonds maturing in five to 10 years, according to data on the week through Feb. 4. That compares with a net bullish wager of $2 billion in the week ended Jan. 7.
The dealers have also reduced their holdings of investment-grade securities of all maturities to $8.5 billion as of Feb. 4, from a net $13.8 billion at the start of the year.
One thing is clear: Banks are increasingly concerned about being on the wrong side of a jarring shift of sentiment. And with yields on this debt at 3.1 percent—within 0.5 percentage point of their all-time low—more analysts see a sudden move as increasingly possible.
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