Investment-grade credit ratings pay off after all

What a difference a few months make for issuers of corporate debt. The average spread between rates on new junk bonds and Treasuries has grown by 280 basis points since August, more than offsetting the decline in Treasury rates. As recently as June, non-investment-grade credit was all the rage. But thanks to the repricing of risk, it’s more cost-efficient today to be investment grade. While the structured finance market has largely shut down because of subprime mortgage turmoil, the investment-grade sector has remained open for business. That environment is likely to continue next year, analysts say, though a recession will make it more costly even for the best corporate credits.

The last few weeks have seen a surge in investment-grade issuance, with such companies as AT&T, Caterpillar, Harley-Davidson and Kraft Foods borrowing anywhere from $400 million to $3 billion apiece. And most of the deals were oversubscribed. In fact, 2007 could be a record year in terms of amount borrowed by investment-grade corporations, with J.P. Morgan, for instance, forecasting about $875 billion worth in the U.S. Nonetheless, investors have been asking for higher risk premiums now that the lending environment for corporations has become riskier than it was at the beginning of the year. Spreads on new bonds have been close to 50 basis points wider than on similar existing bonds, and while that’s making new bonds attractive to investors, it isn’t costing investment-grade corporations as much as it might because the higher spreads are mainly a result of falling Treasury rates.

For instance, the yield on 10-year Treasuries was at its highest point of 5.26% in mid-June, and reached its lowest point of 3.83% toward the end of November—a difference of more than 140 basis points. At the same time, investment-grade spreads are currently wide by historical standards, close to levels last seen about five or six years ago. Spreads of 10-year corporate debt rated A widened by about 95 basis points, to about 190 basis points, between the end of June and the end of November.

To what extent lower rates have offset higher spreads was clear in the case of Kraft Foods, for example, which borrowed $2 billion in 10-year bonds with a coupon of 6.125% in the first week of the month. In August, it floated $1.5 billion worth of bonds with a similar maturity with a 6.5% coupon.

Ten-year treasury yields had risen a touch to 4.15% as of a week ago, but the Federal Reserve’s interest rate cut last week by another 25 basis points, to 4.25%, could prompt yields to stay low. That will in turn fuel more bond issuance.
So it looks as if investment grade will continue to have an advantage over junk credits until conditions change dramatically. All bets may be off for financial services companies, however, as they struggle with write-downs related to subprime mortgages and collateralized debt obligations. Only a few financial services companies have tapped the bond market recently, instead selling preferred notes or stock to sovereign funds. And the cost of debt even for solid non-financial credits may rise significantly if macroeconomic conditions change. Although the balance sheets of most corporations are still in good shape, the chances of a recession next year are growing, and if one materializes, spreads could widen further without a commensurate decline in Treasury rates.