Investment Grade Corporate Bonds: Beware the Risk

How to Secure Your Holdings from Encroaching Socialism

By Eric Roseman

With the economic and financial landscape changing constantly amid an ongoing global credit crisis, investors should take immediate precautions in the event the United States does not provide a blanket guarantee of senior bank debt that fall under the prospects of nationalization.

Since last November, I've been recommending and purchasing investment grade corporate bonds in the United States, including a portion of my company's cash liquidity. The sector crashed last September following Lehman Brothers' (LEHMQ.PK) bankruptcy and has since enjoyed a big rally - until recently.

Indeed, the credit crash in September was a seminal event that drove bond yields north of 7.5% in just a few days. The last time investment grade bond yields were trading at such a wide spread compared to Treasury debt was back in the early 1930s.

With most investment grade bond indices holding about 35% to 50% of their assets in mostly senior bank debt, it's vital to understand how the perception of risk has changed as the United States probably succumbs to some sort of bank nationalization.

Investment grade bond indexes have been correcting since late January and recently crossed below their important 200-day and 50-day moving averages, suggesting another correction or worse might lie ahead.

Will investment grade bank debt fall under a federal guarantee?

Failure to guarantee these bonds will result in another major crash for credit markets because so many institutions, including pension funds and insurance companies, continue to hold bank debt issued by Citigroup (C), Bank of America (BAC) and many others.

Last year, bonds issued by Wachovia defaulted following the ill-fated bank's purchase by Citigroup. In other words, Wachovia bondholders were wiped-out. The same was true for most Lehman issued bonds, particularly in Asia.

Credit spreads for this high value sector have indeed narrowed since crisis heights in October but remain historically elevated at 384 basis points, or 3.84%, above Treasury bonds. In the latest week ending February 23, the Dow Jones Corporate Bond Index has seen its yield rise from 6.38% to 6.58% - a significant jump.

On a bullish note, however, investment grade non-financial issuance has been red-hot since December, including even FDIC-backed bank debt.

The Logistics of a Federal Guarantee for Investment-Grade Debt

It's hard to believe the government can offer a blanket guarantee on all distressed bank bonds - even those that come under nationalization. That's because there's just so much of it still outstanding; Lehman Brothers had more than US$160 billion dollars' worth of debt before it failed.

Combining blanket guarantee across swathes of failed institutions will probably cost the governments trillions of dollars. Should that occur, funding costs will surge because the United States Treasury will have to expand issuance to finance a senior bank debt bailout.

So my strategy is the following:

If you own investment grade bonds or ETFs in this sector, then place a 10% stop loss on your entry price. If that price is violated, then sell. I would not purchase these securities now in light of recent nationalization efforts abroad this month and the strong likelihood of government ownership occurring in the United States.

With the rules on stocks, bonds and other assets changing constantly in this crisis you must take prudent steps to plan a quick exit strategy.

I could never have imagined that senior bank debt would default or come under suspect. But this is the reality of the world we live in and we must be vigilant to protect our assets.

Disclosure: no positions

Comments

[groove:]

Which Wachovia bonds defaulted? When did Citi take over WB?

Feb 26 08:38 AM

[Chris B:]

The question is, will we have a Swedish solution or a Japanese solution to the bank crisis? Anyone unaware of these early 1990's precedents should be doing their homework now.

If it's Swedish, bank bondholders can expect to take a severe haircut.

If Japanese, the zombie banks will continue to provide an income stream for the long run, propped up by government cash.

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Three factors that suggest the solution will be Japanese-style:

-Americans go into a red-baiting frenzy when the word "nationalization" is used. It's considered the equivalent of communism, although few see the everyday actions of the FDIC that way.

-As the world's reserve currency, the US has (or feels that it has) the ability to capitalize the banks to ensure that nobody gets hurt.

-Bank bond defaults could destroy many defined-benefits plans and anger retiree voters.

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Three factors that suggest the solution will be Sweden-style:

-Bank bondholders are demographically more likely to be sending campaign contributions to the political party that won't be making the decision.

-Greater foreign ownership of US bank bonds means that there are even fewer votes to be won by bailing these investors out.

-The Japanese experience.

Feb 26 11:15 AM

[Stock Marke...:]

The will end up covering the preferreds and bonds of the banks, for the reasons in your article, they have to!

Feb 26 11:24 AM

[Shakedownst...:]

Your intentions are good here, but please clarify the statement: " bonds issued by Wachovia defaulted following the ill-fated bank's purchase by Citigroup"...

Feb 26 12:39 PM

[Sicall:]

Good advice. I am sure the US government will avoid "Nationalisation" at all costs. But i have to admit the risks are high in financials bonds at the momment.

I think the best policy on bonds is to keep to the defensive sectors as in equities. Pharmas, Energy and Telecoms and stick to high Grade.

Mar 01 07:41 PM