Corporate bonds had a difficult summer, but currently wide spreads present opportunity for patient i...
Corporate bonds had a difficult summer, but currently wide spreads present opportunity for patient investors.
It will take time for profits to improve and leverage to decline but it appears to us that the corporate world is foregoing the financial strategies driven by greed in favour of strategies driven by financial fear. However, for corporate bonds to outperform in the next few months, the US economy will need to avoid a double-dip recession.
Our house view is that a double dip in growth will be avoided, although the risk remains on the downside as far as economic growth is concerned. While uncertainty about the path of the economy remains, the low inflation environment does give the Federal Reserve (FED) scope to cut interest rates again if required. The most recent comments from senior Fed officials indicate that, despite moving to a negative bias at the last Federal Open Markets Committee meeting, they are in no hurry to cut rates.
The current environment will remain tough for corporations. A tremendous amount of overcapacity was laid on during the fat years of easy financing. During a period of low final-goods inflation, only companies with market-leading shares will have the scope to maintain pricing in line with rising costs. As a result, profit will probably only rebound slowly in the next few quarters.
On top of the uncertainty about the macro picture, the corporate bond market has had a series of stock-specific shocks to contend with, including WorldCom's bankruptcy and Alcatel and Ericsson seeing their debt downgraded to junk bond status.
Obviously, stock selection is key in the current market: credit landmines can blow away bits of investors' capital.
Nonetheless, fear currently rules financial management, which will benefit corporate balance sheets over time.
Companies are drastically reducing their dependence on short-term debt and CP, which betters their liquidity.
Corporations are selling assets to reduce debt. Available cashflow is also going to reduce debt. Cash expenses are being trimmed in order to improve available cash flow. Unneeded plants are either being sold or consolidated through acquisitions.
Most importantly, stock prices of individual companies are rising on announcement of efforts to reduce debt: this means that the stock market is rewarding financial virtue.
So with uncertainty over the direction of the US and global economy and clouds overhanging several sectors, which areas offer a reasonable risk/ reward trade off at present? Telecommunications companies will benefit from their efforts to reduce debt. UK life insurance companies are looking cheap, making the high quality companies among them very attractive. US utilities are also relatively cheap and benefit from the low interest rate environment.
Given a low growth scenario, it is too early to be heavily exposed to basic materials or to capital goods makers.
Credit spreads look attractive.
Corporates continue to mend balance sheets.
Stock market rewarding financial discipline.
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