Demand rather than fundamentals has been driving down yields and encouraging investors to buy into lower quality paper. They should beware because this technical support for the market is not going to last forever
Concerns about a possible war with Iraq and sluggish economic growth have weighed down global equity markets so far this year. However, corporate bonds have been on a downward, but volatile, trend since last November.
This contradictory message ' corporate bond investors are demanding lower returns, compared to equity investors who are demanding higher returns to compensate for the increased uncertainty ' is due to strong technical factors, rather than any fundamental improvement in the quality of companies' business prospects.
Essentially, institutional investors have been minimising the risk in their portfolios by aggressively reducing their exposure to equities. But with yields on government bonds already at extremely low levels, they have been forced to look elsewhere for higher-yielding assets in order to be able to match their pension liabilities.
This is particularly true for UK and European institutional investors, who hold far larger proportions of their investments than their US counterparts in equities and have thus been more seriously affected by the sharp decline in equity markets.
They originally shifted into top-rated corporate bonds, which provide the greatest assurance. However, as these bond yields converged with those of government bonds, they started to look further down the credit rating spectrum in order to meet their objectives. Hence the contraction in BBB and high-yield bond yields, across most sectors, in recent months.
This urgency to swap out of equities and into corporate bonds has also been clearly reflected in the new issuance market.
Whereas six months ago when primary markets were closed to all but the highest quality issuers talk revolved around whether a credit crunch was developing, now new issuance volumes have picked so dramatically in response to the heightened demand some are questioning whether another investment bubble is forming.
Although top-rated issuers are still taking advantage of the current low interest rate levels, the bulk of recent issuance has been by opportunistic lower-quality companies.
An example of this is the Asian conglomerate Hutchinson Whampoa, which recently issued a $1.5bn bond in the US market after failing last year to secure sufficient interest, at an acceptable yield, in Europe.
The company's fundamentals have certainly not changed that significantly; it is investors' appetite for corporate bonds that has. In fact, companies are even successfully launching 30-year bonds in Europe, which is a novelty.
In our view, this trend is unsustainable: we strongly believe that fundamental factors will eventually override the current drivers of the market.
The global economic recovery will be sluggish at best, and Europe's weaker still. The risk of deflation has abated but instead there is the possibility central banks, no doubt fearful of the deflationary spiral gripping Japan, will over-inflate instead. This would be negative for bonds generally, because inflation erodes the value of fixed-payment investments.
Another factor that companies across a variety of industries are still struggling with is vast production overcapacity. This also weakens their pricing power, making it difficult to grow revenues. Profit growth will therefore be heavily dependent on cost-cutting initiatives, a fact that has not been lost on companies, which have been zealously shedding jobs and containing capital expenditures.
Admittedly, companies are also working hard to strengthen their balance sheets, chiefly by paring down their debt levels. The European telecommunications sector is a good example of this: BT's net debt, which peaked at £28bn in 2000, had fallen to £10bn at the end of January; the Netherlands's KPN shows a similar trend, while both France Telecom and Deutsche Telekom are expected to exhibit some improvement this year.
This aggressive debt reduction, coupled with tight cost-containment, has translated into improving credit quality, and is certainly a positive development for corporate bond investors; however, it is not enough to offset the myriad of uncertainties affecting the market.
Market volatility has increased significantly because investors remain highly sensitive to disappointing corporate news. For example, last month the Dutch food retailer Ahold warned that profits for 2002 would be far lower than expected because it had uncovered accounting irregularities in its North American food services subsidiary; the company's chairman and chief financial officer both resigned.
Ahold's debt was downgraded to sub-investment grade by Standard & Poor's, and yields shot up to 18% from around 7%. Although we don't believe that this is necessarily the beginning of an Enron-like wave of accounting anomalies being brought to light in Europe, other high-profile companies could, and indeed are likely to, face difficulties in the near future.
Furthermore, credit rating agencies, whose credibility was badly tarnished when they failed to identify dud credits as significant as WorldCom, are now aggressively downgrading companies. Only last month Standard & Poor's put 12 pan-European companies on a watchlist because of concerns about their underfunded pension liabilities ' an issue which has only recently regained prominence, both in Europe and the US.
The German conglomerate Thyssen- Krupp was the only one to be actually downgraded, although its descent into the sub-investment grade ranks was clearly evident in its sharply wider spreads. Because institutional investors are often prohibited from investing in sub-investment grade credits, a rash of downgrades could trigger some forced selling and more volatility.
Because of all these factors, the beginning of this year was an excellent opportunity to reassess the credit quality of individual issuers, focus on sectors offering relatively stable earnings prospects, and limit our exposure to financially-solid companies that are more likely to withstand a worsening economic outlook. We particularly like financial institutions, most of which recently reported reasonably good results, and autos, but remain extremely negative on capital goods.
Good portfolio diversification is important as it helps to mitigate the impact of disappointing events surrounding any particular stock. Unlike equities, the downside risk for corporate bonds is typically far greater than any upside potential, and corporate bond fund managers' performance depends far more on how successfully they avoid the scandals and disappointments than on their ability to pick winners.
Focusing on high-quality companies is especially important today since a US-led war against Iraq is causing such uncertainty. Investors are likely to become increasingly credit-conscious as any military conflict erupts, and extremely so if it is not expeditiously resolved. Global growth prospects are already subdued, and if the price of oil lingers above the $30 per barrel mark for some time, it could take its toll on consumer sentiment, the linchpin behind the US economic recovery, and exacerbate weak corporate expenditure.
Corporate bond spreads could widen significantly. Sectors that depend on discretionary consumer spending, such as leisure and travel, would likely be among the weakest. Once the conflict has been resolved, it is possible for credit markets to recover quite sharply. However, we believe that any relief rally will be contained by the challenges still facing the global economy, and that the risks remain on the downside. A conflict that drags on for far longer than expected, or that triggers a wave of retaliatory terrorist attacks on the West, is a risk not factored into the market at present.
A final risk for investors to bear in mind is whether or not the UK will adopt the euro. Despite the five tests championed by Gordon Brown, the decision will be ultimately a political one. Prime minister Tony Blair is plainly far keener to join than the Chancellor, but his reputation is likely to hinge on the outcome of the current Iraqi crisis.
Were the UK to join today, however, bond yields would have to adjust: yields on long-dated European bonds are higher than comparable yields in the UK, while yields on short-dated European bonds are lower than those in the UK. Consequently, long-dated UK bond prices would fall and their yields rise, while short-dated UK bond prices would rise and their yields fall.
Corporate bond market will be subject to further defaults.
Companies with stable earnings prospects are likely to fare better in worsening economic outlook.
Corporate bond spreads could weaken further, companies exposed to consumer spending could be worst hit.