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US corporate bond spreads over Treasuries held steady on Thursday, but investors remain nervous that the market may have priced in an excessively strong and sustained economic recovery, leaving it vulnerable to a pullback. "Risk premiums have contracted dramatically over such a short period and it is time to step back and really reassess where we are," said Mark Freeman, senior vice president and portfolio manager with Westwood Holdings Group in Dallas.
The eye-catching rally in corporate bonds since investment grade yield spreads hit record wides of 656 basis points over government bonds in December has been driven by investors' accelerating stampede back into riskier assets. That drove yield spreads down to a recent low of 230 basis points on September 22, according to Bank of America Merrill Lynch data.
Yield spreads have widened 5 basis points since. On Thursday, the costs to insure corporate bonds against the risk of default edged up slightly. The main index of US investment grade credit default swaps widened about 1 basis point from late Wednesday to 103 basis points, according to Markit Intraday.
Over the past two months, traders and bond fund managers have warned the rally may have run too far before any sustained improvement in the economy and corporate earnings. "From a risk standpoint, there has to be an element of doubt because I don't think a straight-line economic recovery is a certainty by any means," Freeman said.
With US earnings season now under way, corporate bond investors are paying especially close attention to companies' balance sheets and to the stock market's reaction to financial results. The US high yield bond market has delivered record returns of about 49 percent this year, according to Bank of America Merrill Lynch data.
"I am beginning to be worried about the duration and length of the move," said Matthew Stedman, head of fixed income sales and trading at investment bank Morgan Joseph & Co in New York. So far, "we haven't seen the explosion of defaults I thought would happen," but many may have been delayed rather than averted, Stedman said. Among financial firms, there was some focus on embattled US lender CIT.
Pacific Investment Management Co and Baupost Group have quit a committee of CIT's largest bondholders, which could indicate support for any kind of debt-exchange restructuring is in jeopardy, sources told Reuters on Wednesday. The departures by PIMCO and Baupost are seen as yet another setback for CIT as the 101-year-old commercial lender has scrambled to convince creditors to support a sweeping debt restructuring, or the company will file for a pre-packaged bankruptcy.
CIT's 5 percent notes due in 2015 fell 1 cent on the dollar on Wednesday to 63 cents, yielding 15.5 percent and traded steady at those levels on Thursday, according to MarketAxess data. Spreads of oil company ConocoPhillips' 5.75 percent bonds due in 2019 tightened about 10 basis points to around 125 basis points over comparable Treasuries on Thursday, traders said, after the company said it would sell $10 billion of assets over the next two years.

Copyright Reuters, 2009

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