TALK TO ANYONE who works in US debt capital markets and you will be told that a substantial bond market correction is on the way – even that it’s well overdue. The only debate is about precise timing and how long the investor casualty list will be. But looking at just the corporate bond market over the past 18 months, some bankers argue that the fallout happened a long time ago.
Some say that it happened – in the investment-grade market at least – when cable assets plummeted to trade at between 50 cents and 60 cents on the dollar last year. Or indeed when established issuers such as Ford Credit saw their dollar bonds trading on spreads north of 600 basis points over treasuries in the face of unprecedented investor skittishness last October. “Are we going to have a healthy correction? Yes. But it’s not going to be anything as bad as we’ve already had,” is one banker’s weary take on the market.
This sense that the worst has already happened in the corporate bond market has sustained it in 2003 in the face of the twin threats of mediocre corporate credit quality and a potential rise in interest rates. Such worries haven’t stopped new investors piling into bond market funds, in particular high-yield, at a rate not seen in years and directly into the bond market at spectacularly expensive levels.
Are they being suckered in?
The US corporate bond market is now displaying worrying signs. For the first time since last November, technicals and fundamentals are at odds. Technical features, particularly the size of inflows into fixed-income funds, have pulled corporate spreads in so much since their October wides they have prompted the best six-month performance of the US credit market ever. Corporate spreads are now at levels not seen since March 2000. The option adjusted spread of Lehman Brother’s US credit index of high-grade issuers was at 123bp at the end of April, tightening 23bp in that month alone.
This is all marvellous news, except for the small point that apart from better than expected first-quarter earnings results, there has been no complementary improvement in credit quality. Yet investors are hurtling into the market, like moths impelled towards the flame that will eventually consume them. Of the US corporate deals priced right at the end of April, every one was three to four times oversubscribed and tightened after launch. They are still happily buying into a rally that is unsustainable.
Corporates opportunistically pre-funded in advance of the Iraqi war, taking advantage of interest rates at 40-year lows in January and February. Most eye-catching was the $33 billion of high-yield deals issued last quarter, exceeding any quarterly period in 2002. According to data from Standard & Poor’s, and indicative of the $1 billion of new money a week looking for a home in US high-yield at the moment, the US high-yield market has tightened over 140bp since the end of last year. This has led to an extraordinary state of affairs – at press time, double-B rated credits such as XTO Energy were able to issue 10-year bonds with coupons of just 6.25%.
Overall corporate issuance in March fell off a cliff and April’s figures were no better, despite issuance picking up towards the end of the month. This is bad news for the banks where debt capital markets teams are already overstaffed and bad news for the investors watching corporate spread levels get tighter and tighter who are forced to buy up anything on offer. “Investors are overweight on corporates because they think they will improve, and at the same time there is a lot of investable cash and few jumbo deals to invest in,” says Bruce Widas, managing director at UBS Warburg.
New issues were running at near-record levels in the first two months of this year but overall primary-market activity in the first quarter of $154 billion was still less than in the same period in 2002. And some US debt capital markets bankers even think the consensus prediction of 20% less high-grade issuance in 2003 than in 2002 is optimistic if issuers have finished their pre-funding for the year.
No cause for celebration
If issuance levels now fall further, credit bond spreads – which, according to S&P, are at their least volatile since S&P’s fixed-income indices were calculated back in December 1998 – could be set to tighten even more in the coming quarter.
But corporate credit fundamentals are hardly any cause for celebration. Investors may believe that deleveraging is a universal fact of life and that corporate balance sheets look a lot healthier these days. In fact, in the US it was only in the TMT sector that total debt levels fell between 2001 and the end of last year, according to data from independent credit research firm CreditSights, which looks at the largest US non-financial investment-grade issuers in the Merrill Lynch corporate bond index.
Average debt to market capitalization was 35.7% at the end of 2002, compared with 35.8% at the end of the previous quarter, a long way from the 25% levels typically prevailing in the US in 2000/01. Although this figure partly springs from declining equity valuations, the aggregate amount of total debt outstanding also went up from the end of 2001 to the end of 2002.
Analysts don’t think there will be a downward move in aggregate total debt outstanding until later this year but as Raj Dhanda, co-head of global debt syndicate at Morgan Stanley, points out, right now corporates are not looking on this as a number-one priority.
“The discussion of deleveraging for companies has been more significant that the reality,” Dhanda says. “In fact, companies aren’t paying down so much debt, just building up more cash. The corporate investment-grade market has rallied by 100bp in a very short space of time so companies need to keep paying down more debt to justify a continued rally.”
Recent data from rating agencies hardly paint a rosy picture about credit quality either. According to Moody’s, the trend for US and global credit quality is still downward. There were fewer ratings upgrades in the first quarter of 2003 than in the previous quarter, down to 1.3% of Moody’s issuers from 1.8%. Although only 5.1% of issuers were downgraded compared with 7.9% the previous quarter, the overall direction remains down. There is more to come. Moody’s points out that the airlines are looking at the prospect of further credit decline and CreditSights agrees that there could be an increase in downgrades, particularly with the ratings pressure on the biggest auto manufacturers.
CreditSights points out that although the big three auto makers and some of their suppliers were showing worsening risk in March than over the previous six months, according to their BondScore credit risk estimates, spreads on Ford’s bonds have tightened significantly. It also cites the utilities sector, where spreads are tightening well in advance of any improvement in credit quality.
The market also thinks it is ready to deal with future corporate accountancy scandals or multi-notch ratings downgrades. The fear that every company is a WorldCom waiting to happen that gripped the market last year appears to be lifting. The good news is that there was just $5.8 billion of fallen angel volume in the first quarter compared with a quarterly average of $50 billion in 2002. In the words of one senior US debt capital markets banker: “The event risk is always there, but we feel we have our arms around it.”
But it is probably a bit too hasty to declare a new maturity in the way the market handles these events. Details of the widespread fraud perpetrated at HealthSouth are still coming to light and the market only has to look back a few months to recall the one of the single biggest one-day price moves in the investment-grade market as a result of the Ahold scandal.
Some bankers believe that investment-grade bond spreads could still tighten further. “The pricing premium is still substantial in investment-grade, so there’s room for more of a rally, whereas in high-yield, absolute rates are still as low as 7.5%,” says Bill Hodges, head of global debt capital raising at Banc of America Securities.
Bullish analysts argue that investors must have witnessed some improvement in corporate fundamentals during the latest quarterly earnings results and that the market could not rally 23bp in one month on the technical bid alone, but to justify a continued rally the economy would need to be in better shape and top-line growth would have to start emerging.
Profits sustainability looks uncertain
Equally though, the weak US economy could cause corporate spreads to give up some of their recent gains. Despite a few positive surprises from April’s earnings season, such as AOL Time Warner’s first quarterly profit as a merged entity , the outlook for corporate profits remains uncertain.
Profits that have come as a result of extensive cost-cutting are not sustainable and, according to CreditSights, a recovery in corporate capacity utilization is still at least a few months away.
And even if corporate spreads tighten further as demand outstrips supply even more, or if corporate fundamentals do improve, an interest rate rise as a result of the US economy improving could blow a hole in the market anyway. The spread markets have certainly suffered in this way before – February 1994 saw a blood bath for corporates after a similar change of stance by the Fed.
Bond prices at the short end of the treasury curve are particularly high at the moment. According to a global debt market strategy report issued by Merrill Lynch on April 16, a major setback for global bonds could only come from an actual or anticipated change of stance from the Fed and a violent bursting of the bubble at the front end of the treasury curve.
As a result, global yield curves could suffer front to back. “As sure as death this will eventually occur,” say the report’s authors, “but from a fundamental perspective we believe we are not there yet.”
Mixed signals on US economy
At the moment, US economic indicators are hardly positive, prompting some predictions of one or two more interest rate cuts. The Fed’s Beige Book survey released in April showed that consumer spending was depressed and that the employment market remained soft in March and the first two weeks of April. CreditSights predicts that in the absence of brighter news on the economy, technical support for the market should continue until the third quarter. The signals are mixed. Durable goods orders increased in March, hinting at a possible recovery in business investment.
Louise Purtle, head of US credit strategy at CreditSights, suggests that the results of an interest rate increase might not be as dramatic as some people believe anyway. “People are inclined to call a bubble whenever prices in an asset class have sharply appreciated, but whether the definition of bubble is justified has to be measured by the speed with which prices eventually go down.”
She says that history shows that funds will continue to go into fixed income until the beginning of the quarter in which the Fed raises rates. “At that time, the question is really more which of the fixed-income markets will see inflow. In a stronger growth scenario for instance, treasuries will suffer but you would expect to see high-yield outperform. Investors are clearly sensitive to mark-to-market moves, but corporate debt is well suited to long-term investment strategies such as retirement saving, so even when we enter the interest-rate up cycle we do not expect to see a wholesale abandonment of the asset class.”
Purtle adds that it will only be if the dollar goes into swan song or global investors decide that they don’t want US fixed-income assets any more that will do for the asset class altogether.
Nevertheless, when interest rates do go up, as they inevitably will, watch out. As the head of debt at one bank says: “Every business has a cycle and this debt boom will come to an end. One worries about over-reliance on any asset class. Are investors sophisticated enough to understand the duration and present value of assets in a higher-rate environment?”
Investors buying corporate debt at these expensive levels and expecting further upside are playing with fire.
What Prospects for corporate growth
|
Widas: sees in bank bond issuance a first hint that corporates are stepping |
The saying goes that what is good for bondholders is bad for shareholders. Corporate managements in the US have encouraged shareholders to learn a new patience over the past 18 months as they have restructured their balance sheets, shelved investment and paid down debt to survive. Shareholders may feel that they are now justified in pushing for growth again, but they shouldn’t hold their breath.
Certainly, corporates are not financing growth in the bond markets, even though they can issue at historically low rates. Libor rates are even lower so it is not worth borrowing if they don’t need the money immediately. “Indicators of new debt issue growth will be that short-term debt is increasing, debt-financed M&A is taking off and capex spending is increasing, but we have not seen any signs of this yet,” says Bruce Widas, managing director at UBS Warburg.
Companies are not increasing capital expenditure because they do not have the top-line growth to justify this and there is still a lot of pessimism about the economy. “The fundamental thing that a CEO lacks at the moment is a solid view of the business for the next few months,” says Bill Hodges, head of global debt capital raising at Banc of America Securities.
Data on the US M&A market also looks pretty grim. Activity in the sector fell to its lowest point in nine years for the first quarter of 2003, with announced bids for US targets of just $67 billion. Bankers give anecdotal evidence that the market is picking up – there has been a recent spate of deals in the US chemicals sector, for example – and that the pipeline is looking a bit better, but there is not much hard evidence to suggest that CEOs’ animal spirits are reviving.
Companies do not want to sell at the moment – unless they are really distressed sellers – and even buyers are cautious. “Lots of M&A deals are being considered,” says one banker. “One aggressive team thought they had a slam-dunk deal, but their own board said ‘you are moving too fast’.”
Corporates are starting to increase short-term debt. Non-financial commercial paper is beginning to increase slightly, having been on a straight line down since 2001. Widas also thinks the number of banks issuing in the US bond market recently because they have asset growth may be the first hint that corporates are increasing bank borrowing to fund M&A and other growth-oriented investment.
But it is difficult for corporates to engineer equity outperformance anyway. And plenty of equity strategists still think US equities are overvalued. As one puts it, “You have to consider what companies can deliver to the investor, and they can’t deliver any growth without the broader macroeconomic conditions improving.”
