Nowadays, almost everything seems to be driven by the performance of the equity market, and the bond market is no exception.
Interestingly, the equity market performance attracts the undivided attention of investors, while the developments on the bond side rarely attract the public interest, in spite of the huge sums invested in this asset category. Looking at the poor performance of the equity market since the beginning of the year (MSCI World minus 20 percent in USD terms), one could argue at first sight that bondholders should have had a great time since the beginning of 2002. This conclusion unfortunately holds true only in part: in general, bondholders were blessed by decreasing interest rate levels, but this effect was adversely affected for corporate bonds holdings by the widening of the credit spread! The direction of some corporate debt securities has been in parallel with the poor performance of the corresponding equities.
Corporate bond owners have to cope with an increasingly difficult environment. They are faced with a dramatic rise in default rates partially due to the impossibility to reduce leverage by issuing new shares. According to a recent Moody’s study on European corporate bonds the total amount of debt securities that ended in default between January and May 2002 accounted for approximately 24 billion euros, which is more than during the previous 17 years! The telecom sector contributed to half of the total positions at risk, followed by the transportation sector.
Not surprisingly, rating agencies are blamed for being rather reactive than proactive in examining the real financial situation of corporates. It is more than normal that this leads now to the contrary, i.e. to an “irrational exuberance” in the sense of hyperactivity. Investors should not adopt a similar decision-making behavior.
We have observed some trends which reveal pricing differences of risk premiums across various sectors, which lead to investment opportunities. For example, a comparison of 10-year bonds reveals that selected financial services companies excessively suffered from price reductions and therefore are attractive for investments, if the underlying financial data is sound. Of course, this does not facilitate the investment decision, on the contrary. The sharp decline in equities amid accounting concerns, profit warnings, rating actions and incumbent insolvency rumors caused credit spreads (excess yield against treasuries yield) to widen a lot; better sectors have fallen along with the rest of the market. Nervousness reached peaks in mid-July when daily stock market variations in excess of 5 percent were not uncommon.
One of the sectors, which was the exception to the rule for much of the current year is basic materials. In an environment with widening spreads, all sectors across the board, i.e., from the traditionally defensive utilities to the more exposed telecoms (Telefonica Moviles!) and automotives (Fiat!), were negatively affected. The cable sector suffered the most and reached yield pick-ups of up to 400 basis points for investment-grade securities. Selling pressure also continued in the consumer-related and in the industrial sectors, which have been relatively resilient to the general spread widening.
Financials had a hard life and are still facing huge problems. The banking sector suffered the effects of weaker earnings, shrinking margins, declining proceeds from commissions, potential credit losses, and an almost dead investment banking market.
We expect the concerns regarding the capitalization and profitability of financials to continue for much of this year; it is difficult to expect a sustainable stabilization of spreads during the next months. One implication of the sluggish stock market might be the acceleration of consolidation in the sector affecting especially small-to-mid size companies.
Given the unappealing current status of the corporate bond market, investors are eager to learn about the future. How many of the originally high-grade companies will have converted into high yields? The future is not to be seen as dark as the emotional-driven market may suggest! We are confident that improving macroeconomic conditions will allow corporate bonds to outperform government issuers. Most of the bad news and mid-year results’ information of the largest telecoms, industrials and financials has already been priced in, and this should help dampening the extremely high volatility over time and gives confidence on a turn-around in the second half of the year.
Improving SEC regulations, as announced by various political leaders, may trigger an accelerated due diligence process and consequently reduce concerns about “creative” accounting practices and lower the probability of a credit crunch. The current clean-up process is the price that has to be paid to revive the market.
As soon as investors will regain confidence, the new issues flow will pick up again and regain momentum. As we expect a recovery of the economy, we express interest to switch from defensive non-cyclical sectors to more cyclical ones.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management)