By Bryan Keogh Feb. 23 (Bloomberg) -- Corporate bond returns in the U.S. are lagging behind Europe by the most in a year, a trend that Wall Street’s biggest banks say is poised to reverse as the economies of the two continents diverge. Morgan Stanley, Citigroup Inc. and Bank of America Corp. recommend clients favor company debt in the U.S. after investment-grade securities lost 0.97 percent this month, compared with the 0.11 percent gain in Europe, as measured by Bank of America Merrill Lynch indexes. The gap in performance is the most since last February, when the difference was 1.21 percentage points. Strategists are turning bullish on U.S. credit markets as economists estimate growth will be more than double that of Europe, making it easier for borrowers to meet debt payments. Dollar-denominated bonds sold by New York-based Pfizer Inc. and Deutsche Telekom AG, Germany’s largest phone company, both yield more than 1 percentage point above their euro debt. “The macro backdrop in the U.S. certainly seems more sustainable and supportive of credit,” said Andrew Sheets, a Morgan Stanley strategist in London. “The valuation of credit relative to all the other fixed-income instruments you can buy in the U.S. looks much more compelling than it does in Europe.” Yield Spreads Dollar-denominated debt yields more than bonds sold in Europe even though rising budget deficits in Greece, Portugal, and Spain threaten to slow the region’s growth. The extra yield investors demand to own U.S. investment-grade bonds instead of Treasuries narrowed 1 basis point yesterday to 185 on average. In Europe the gap tightened 1 basis point to 160, or 1.6 percentage points. Elsewhere in credit markets, the extra spread on company bonds globally shrank 1 basis point yesterday to 168 basis points, Bank of America Merrill Lynch’s Global Broad Market Corporate Index showed. The gap is the narrowest since Feb. 4, when it was 166 basis points. Yields fell to 4.16 percent from 4.18 percent on Feb. 19. Relative yields on commercial mortgage bonds rose for the first time in two weeks as banks forecast an increase in delinquencies. The spread as measured by the BarCap CMBS AAA Super Duper Index widened yesterday by 2 basis points to 310. The spread is down from 396 basis points at the end of 2009 and 1,100 a year ago. Mortgages, Swaps The amount of distressed commercial mortgages in bonds may double to $60 billion this year, according to Credit Suisse Group AG. Loans that are 90 days past due, in foreclosure, or already seized, are $28.8 billion, Credit Suisse analysts led by Gail Lee said yesterday in a report. Credit-default swaps tied to the debt of 125 investment- grade borrowers on the Markit iTraxx Europe Index rose 1.25 basis points to 84.75 at 9:45 a.m. in London from the lowest level in almost three weeks, JPMorgan Chase & Co. prices show. In the U.S., the cost to protect against defaults on corporate bonds is the lowest in a month as better-than-forecast earnings spur investors to wager on the economic recovery. The Markit CDX North America Index of credit-default swaps on 125 investment-grade companies was unchanged at a mid-price of 91 basis points, according Phoenix Partners Group. Of the 407 companies in the S&P 500 index that have posted fourth-quarter results, 76 percent have reported profit that beat analyst estimates, according to data compiled by Bloomberg. S&P says 12 issuers with debt of $20.3 billion may be increased to investment grade, the same amount as the average over the past 12 months. The number in jeopardy of being cut to speculative grade is 71 with debt of $186.9 billion, down from the 18-year high of 82 in March. ‘Double-Dip’ Risk Credit-default swaps are derivatives used to hedge against or speculate on companies’ creditworthiness. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A basis point on a contract protecting $10 million of debt from default for five years equals $1,000 a year. “In terms of economic news and company-specific news, you see upward revision in the U.S. compared with downward revision in Europe,” Mikhail Foux, a credit strategist at New York-based Citigroup, said. In Europe, the odds of a “double-dip” recession are increasing because of sovereign deficit concerns, strategists led by Foux wrote yesterday in a report. Separately, International Lease Finance Corp., American International Group Inc.’s plane-leasing unit, said it was seeking a $750 million loan to refinance debts. The loan will be secured against aircraft and related leases, ILFC said in a Business Wire statement today. Greece Debt Crisis European investment-grade corporate bonds have outperformed U.S. securities this year even as Greece’s debt crisis infected its southern European neighbors and as the European Union pledged assistance for the government in Athens without specifying what form it will take. Euro-denominated notes have returned 1.62 percent in 2010, compared with 0.97 percent in the U.S., according to Bank of America Merrill Lynch index data. That’s mainly because credit markets in Europe have benefited from a drop in benchmark government bond yields as investors sought refuge in the debt. Yields on 10-year German bunds fell to 0.55 percentage point below similar-maturity Treasuries on Feb. 28, from 0.38 percentage point on Jan. 21. The U.S. economy will grow 3 percent in 2010 and 2011, according to the median estimates of 69 economists surveyed by Bloomberg. The euro-region economy will increase 1.2 percent this year and 1.5 percent next year, a separate survey shows. Growth, Leverage Non-financial U.S. investment-grade companies have total debt of about 2.3 times earnings before interest, taxes, depreciation and amortization, compared with 2.8 times for their European counterparts, according to Morgan Stanley. Corporate credit in the U.S. and Europe has already begun to “decouple,” Bank of America credit strategists led by Teo Lasarte in London said in a Feb. 19 report. Spreads on U.S. bonds have tightened 5 basis points more than those in Europe over the past two weeks, they wrote. “The U.S. has clearly outperformed Europe” in recent weeks, the strategists said. America’s company bonds yield more partly because they have longer maturities and lower ratings. Investment-grade bonds in Bank of America’s EMU Corporate Index have an average life of 4.79 years and an A1 rating, Moody’s Investors Service’s fifth- highest investment grade. Securities in the U.S. Corporate Master index come due in 9.86 years on average and are ranked two steps lower at A3. ‘Best Value’ “U.S. corporate bonds look like the best value from an investment point of view because of the yields available,” said Tim Barker, head of credit research at Aviva Investors, which manages about 10.5 billion pounds ($16.3 billion) of fixed- income assets in London. “As an investor, you are getting more initial bang for your buck with U.S. corporate bonds.” Dollar-denominated debt pays about 2.5 percentage points more than the dividend yield for stocks in the Standard & Poor’s 500 index, Bank of America Merrill Lynch indexes show. That’s almost 14 times the 0.2 percentage-point premium that European debt offers compared with the MSCI Europe equities index, the most since at least 1996. U.S. corporate bonds are also a better buy because a three- month rally in the dollar will probably continue, according to Morgan Stanley’s Sheets. The dollar strengthened to a nine-month high of $1.3444 to the euro on Feb. 19. It will appreciate 8 percent this year, according to Morgan Stanley. Profit in Switch Investors can profit by switching out of euro-denominated bonds into dollar securities of the same issuer, which in some cases yield more than a percentage point higher, Sheets said. Pfizer’s $500 million of 6.5 percent dollar-denominated notes due in December 2018 yield 4.8 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. That compares with a rate of 3.5 percent on the world’s largest drugmaker’s 900 million euros of 4.55 percent securities due in May 2017, about the widest gap since the securities were sold. The $850 million of 6.75 percent bonds due in August 2018 sold by Deutsche Telekom AG, Germany’s largest phone company, yield 5.1 percent, 1.1 percentage points more than the Bonn- based phone company’s 500 million euros of 6.625 percent notes due in March 2018, Bloomberg data show. “We don’t think it makes sense for these wide relationships to be there,” Sheets said. To contact the reporter on this story: Bryan Keogh in London at bkeogh4@bloomberg.net

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