The Debts of the Spenders: European Corporate Bond Party Over?

Emphasis my own.

=DJ HEARD ON THE STREET: Easy Corporate Bond Gains Now Past

By Richard Barley A DOW JONES COLUMN

The party in the European investment-grade corporate bond market this year has been remarkable. Nonfinancial bond issuance in the first half looks set to top the current EUR200 billion record for an entire year. Meanwhile spreads have nearly halved, generating huge gains for investors. But the easy money has now been made.

True, investment-grade spreads are still well above what is needed to compensate for default risk. Since 1970, investment-grade bonds have never needed to offer more than 28 basis points of spread to compensate for defaults over a five-year period, assuming average recoveries, according to Deutsche Bank. Yet the Markit iBoxx euro nonfinancial index currently stands at 199 bps over government bonds.

But further major spread tightening is unlikely. Corporate bonds have always traded with a substantial illiquidity premium. The debate is over what the "new normal" should be. The best bet is that risk premiums will stabilize at much higher levels than in the past.

First, credit risk is still rising. Defaults are expected to reach the highest levels since the 1930s. Since October 2008, the ratio of global ratings downgrades to upgrades has not dipped below 7.6 to one, according to Moody's. And downgrades to junk, which can force investors to sell at a loss, are surging. Meanwhile, new issuance is increasingly from lower-rated, higher-risk companies, so average spreads should remain higher.

Second, new issuance is likely to remain high as borrowers seek alternatives to bank funding while investor appetite could start to ebb. That's partly because investment grade corporate bonds face renewed competition from other parts of the credit markets as they open up, but also because discounts on new issues have narrowed sharply.

Finally, the reduced competition from banks should mean bond spreads settle at a higher level. During the boom, banks used cheap loans as a way to generate high-fee corporate business, dragging spreads down. Now bond investors have more control over pricing.

That suggests investors can still make good money from bonds. But it will come via patient investing and careful credit analysis - and not the one-off capital gains achieved over the first few months of this year.