Bonds of U.S. home builders, profitable through April, have turned into this year’s biggest losers in the market for debt with ratings below investment grade.
Debt sold by D.R. Horton Inc., KB Home and other construction companies has tumbled an average 3 percent since May 1, saddling investors with losses of about 1.1 percent this year, including reinvested interest, according to indexes compiled by Merrill Lynch & Co. That’s the worst performance of 37 industries tracked by the firm.
The bonds returned an average 2 percent through April when investors were betting the housing market would weather higher interest rates. That optimism evaporated as the Federal Reserve boosted benchmark interest rates in May and June, sending mortgage costs to the highest level in more than four years. An index measuring home-builder confidence dropped to the lowest level since December 1991 this month.
“You have to ask yourself if the worst is over or yet to come,” said Timothy Compan, head of corporate bond strategy at Cleveland-based Allegiant Asset Management.
The extra yield, or spread, investors demand to own home-builder bonds instead of Treasuries is widening as the housing market declines. Bonds in the Merrill index yield an average 3.50 percentage points more than government debt, up from 2.25 points in late April.
Building permits, a sign of future business, fell 4.3 percent in June, according to the Commerce Department. Sales of new houses probably will fall more than 9 percent this year, to 1.16 million from a record 1.28 million in 2005, David Berson, chief economist of mortgage giant Fannie Mae, said in his semiannual forecast last week. Prices could rise only 2.6 percent, a third of 2005’s pace, he said.
Los Angeles-based KB Home, the nation’s fifth-largest home builder by market value, said last month that profit this year will grow at the slowest pace in five years as higher mortgage rates cut demand.
Moody’s Investors Service lowered its outlook on the company’s credit rating to “stable” from “positive” on July 12. KB Home is ranked Ba1 by Moody’s and BB-plus by Standard & Poor’s. Those rated below Baa3 by Moody’s and BBB-minus at S&P are considered below investment grade, or junk.
D.R. Horton, America’s third-biggest builder, said last week it will sell 50,000 houses in the year ending Sept. 30, below the 58,000 estimate it gave April 18.
“Every downturn is longer and deeper than people expect,” D.R. Horton Chief Executive Donald Tomnitz said last week after the company reported the first quarterly profit drop in its 28-year history. “We are assuming the worst.”
The company’s $500 million of 6.5 percent notes due in 2016 trade at 95.53 cents. The bonds yield 7.14 percent, or 2.10 percentage points more than Treasuries, compared with a spread of 1.60 percentage points when they were sold in mid-April. The bonds are rated BBB-minus by S&P and Baa3 by Moody’s.
“It has been pretty painful for investors,” said Brian Arsenault, a high-yield strategist in New York for Morgan Stanley.
WCI Communities Inc., a builder of retirement communities for affluent home buyers, had its outlook reduced to “negative” from “stable” on July 12 by S&P, which cited “several months of sharp order declines” that “show no sign of abating in the near term.”
But the slide among home builders might not be as severe as some people think, said Steven Brooks, an investment-grade debt analyst at T. Rowe Price Group Inc. in Baltimore.
“The credit quality is sound,” said Brooks. Housing companies are “very well positioned to manage through a downturn as long we have reasonable economic and job growth and interest rates don’t go through the roof. It’s hard for me to imagine a serious downturn.”
