US economy is slowing significantly with knock-on effects for bond holders By Jane Wallace Corporate...
US economy is slowing significantly with knock-on effects for bond holders
By Jane Wallace
Corporate bond defaults are rising and are at their highest level since 1991 for Standard & Poor's rated stocks. In the first seven months of this year there have been 61 defaults on S&P rated issues. The most recent high for an annual figure was 65 defaults in 1991.
In addition, the number of companies suffering credit downgrades has significantly outstripped those being upgraded.
Since the third quarter of 1998, S&P has downgraded 143 companies and upgraded only 21. When a credit is downgraded, or a company defaults, the nominal yield on the bond may increase but the capital value is eroded.
US statistics are used because it is the only market large enough to produce meaningful data. It is also a sector where several high yield unit trusts are investing to achieve sufficient diversification from the fledgling European junk bond market.
John Kelly, investment director at BGI Funds, said: "The bond market has retreated since the end of the fiscal year, when many new bond funds were launched in the UK. They probably still have book losses and have had to acquire positions. Now they must allow capital to be exposed or cut income, there is no halfway house."
Kelly said that the statistics were surprising because the US economy provides a benign backdrop for bonds. This was partly the reason for the rush to issue high yield bonds as a cheap form of financing. Low inflation, however, is the key to the number of defaults and downgrades.
He said: "Companies are overleveraging. They have retired equity and produced bonds as the demand for income has increased and bonds were a less expensive way of raising capital. Unfortunately, because inflation is low, they cannot raise prices. If they are geared, then they cannot raise production. There is nowhere left to go."
Kelly noted that US retail sales in first quarter of this year where up 15%, in the second quarter up 5% and in June up less than 1%. Meanwhile, industrial production, not accounting for IT, was unchanged in June on May's figures.
He said: "This is a clear sign of the US economy hitting the breaks. Payroll demand is falling, while housing demand is down. The lower retail figure perhaps show that the confident US consumer has been overwhelmed."
He added that any pick-up in base rates would not help matters. Long-term rates have already risen in both the US and the UK.
At Threadneedle Ted Bacon, director of sterling bonds, said that credit spreads - the difference between the yield on corporates and government paper - have widened significantly in the US and to a lesser extent in the UK. He said this is related to technical issues, such as oversupply of corporates in the rush to issue before the millennium, not credit worries. For this reason he has recently increased his exposure to gilts.
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