Dodging defaults
The corporate-bond market has proved more resilient than feared
Aug 5th 2010
AS INVESTMENT banks toppled in the autumn of 2008, panic swept the corporate-bond market. With bank finance disappearing, company profits under grave threat and a slump apparently on the way, investors feared that a wide range of firms would be forced to renege on their debts.
In the spring of 2009, Jim Reid of Deutsche Bank says, the market was pricing in the prospect of more than half of American high-yield bonds defaulting over the next five years, assuming that investors recovered nothing from the bankruptcy process. On a more typical recovery rate (around 40 cents on the dollar), the markets were pricing in a 69% default rate. That compares with a peak five-year default rate of 45% during the 1930s.
Those gloomy forecasts show little sign of coming to pass. At its worst point in November last year, the 12-month default rate for American high-yield bonds was 11.3%, according to Standard and Poor’s (S&P). That rate is now rapidly declining, with S&P forecasting it will hit 2.8% by June next year. Far from resembling the 1930s, the default rate did not reach the heights recorded in the early 1990s, and was only a little above its level in the early 2000s, when the recession was very mild.
So what went right? The bad-debt problems that emerged in 2007 and 2008 were concentrated in the financial and household sectors. With a few exceptions, the corporate sector had not gone on the kind of borrowing spree seen in the late 1990s. The industrial failures in the crisis included Chrysler and General Motors; companies that had been struggling for years. By contrast, the big failures of 2002, Enron and WorldCom, had been among the high-fliers of the late 1990s.
The corporate sector has also bounced back very quickly from the recession, slashing costs and benefiting from a surge in productivity. According to Société Générale, a French bank, global corporate profits are forecast to rise by 39% this year. Even if financial companies are excluded, profits are set to grow by 33%.
A second factor is that investors’ money had to go somewhere. During 2005 and 2006, investors were chasing yield by buying bonds and structured products linked to the commercial- and residential-property markets. Appetite for those investments evaporated almost overnight.
But the desire for yield has not gone away, especially with cash rates near zero and ten-year Treasury yields at 3%. At the peak in 2009, investment-grade bonds were offering a tempting six-percentage-point yield spread over government bonds, while speculative (junk) bonds were paying a juicy 16-point premium.
Those who took advantage of such yields earned fantastic returns in 2009 as the bond markets recovered. High-yield corporate debt now offers a spread of just over six percentage points; investment-grade bonds around two.
The corporate-bond rally coincided with the phenomenal recovery of equity markets, which similarly reflected relief that economic Armageddon had been avoided. It also had the benign effect of reducing corporate borrowing costs and thus making it less likely that companies will default on their debts. That has allowed banks to take lower bad-debt provisions, which has bolstered their profits in the current results season.
In this sense, the monetary and fiscal stimulus applied by the authorities worked. It staved off a potential collapse of the corporate sector and restored investor confidence.
From here, the prospects for the bond market depend on whether the authorities have been successful in generating a sustainable, rather than a short-term, recovery. Fears of a double-dip recession, and competition in the form of heavy government-debt issuance, help explain why spreads have in effect stopped narrowing this year.
In the absence of an outright recession, it is hard to see spreads widening significantly. Willem Sels, head of asset allocation at HSBC Private Bank, says the temptation to buy high-yield bonds is great because the absolute level of government-bond yields is so low. A six-point spread potentially allows investors to triple their government-bond return.
And were the global economy to show renewed signs of vigour, one would expect corporate-bond spreads to narrow further; they are still well above their (admittedly absurd) levels of 2006 and early 2007. But if that happy turn of events does take place, equities will be a much bigger beneficiary of renewed risk appetite than corporate debt.
Finance and Economics
0 comments:
Publicar un comentario