The last 12 months have been difficult for corporate bonds, but with the economy picking up and debt levels coming down, investors can expect much better returns in the coming months
This year has been a difficult year for credit markets so far, with many issues affecting the performance of corporate bonds.
One area that worried investors in bond markets was Argentina's default. In early January 2002, Argentina announced the biggest debt default in history ' after a period of hyperinflation, it collapsed under the weight of excessive public debt. Argentina's default on its $141bn debt also included international bonds (which was not the case when Russia defaulted).
Another concern was Enron, the energy trading company that collapsed last December and became the biggest company bankruptcy in US corporate history. Enron's collapse was blamed on complex financial arrangements and questionable accounting practices.
Accounting issues have remained on the agenda and in the case of Enron, accountancy firm Arthur Andersen was found guilty in June of obstructing the course of justice. Hundreds of US firms that used so-called aggressive accounting methods have been affected. President Bush recently signed into law tougher penalties for corporate fraud and tighter regulation of companies and accountants. In August, the US Securities and Exchange Commission insisted that all CEOs and CFOs of listed companies should sign off their companies' accounts to attest to their validity.
Not surprisingly during this period, the corporate debt of companies with accounting problems, such as Tyco, Household Finance and Calpine, have all performed poorly.
The weakness of many companies' equity prices has also affected their corporate bonds. In the media sector, the bonds issued by EMI Group, Carlton and the Daily Mail have all underperformed for a variety of specific reasons, but also because the outlook for advertising revenues has fallen. EMI's poor advertising revenues in the US have added weight to negative sentiment about the media sector.
Insurance sector bonds have suffered from a very specific issue over the year. Insurance companies issue subordinated bonds, the repayment of which is linked to the returns of the companies' with-profits funds.
In general, most with-profits funds have a high equity weighting. This has meant that the poor performance of equity markets has caused some concern about the ability of the companies to repay the subordinated bonds. Hence investors have been heavy sellers of these bonds during 2002.
This year, the telecommunications sector, and the performance of the relevant bonds, has been split between the winners and the losers. BT and KPN have managed to reduce their debt, while companies such as France Telecom and Deutsche Telekom continue to disappoint the market on the debt reduction issue. The best performing sectors have been the more defensive areas of food retailing, with Tesco and Sainsbury's performing well, and the oil component of the resources sector. Somewhat surprisingly, given the defensive quality of their earnings, the utilities companies' bonds have not performed as well as might have been anticipated. This sector contains some company-specific risk with British Energy's financial worries having a negative impact on the sector as a whole.
Despite all the bad news, when we analyse the broader corporate bond indices, credit has still produced a positive contribution year-to-date relative to gilts. The problem may be that observers are focusing on some of the returns for the third quarter, which have been rather weak.
In the last quarter, a very defensive strategy would have rewarded investors well, with supranationals being among the better performing non-government bonds.
The tables above highlight that during July and August, gilts were an outstanding investment, in general outperforming all sectors except AAA-rated bonds. The BBB sector was the worst performer with media being the worst-performing industry sector. It is interesting to note that bonds in the telecommunications sector have performed well this quarter, however this seems to have been simply because these bonds had fallen so far rather than because of any improvement in the fundamentals for the companies concerned.
The returns data for 2002 to date shows credit in a better light, with only the BBB 5 year sector underperforming. Media and telecommunications issues have dragged the performance of this rating category down.
The corporate bond market currently remains in a very defensive mood with investors unwilling to take on risk. Is it right to continue to maintain a defensive stance?
Looking to 2003, global growth prospects seem more positive. In the UK, economic activity rebounded strongly in the second quarter of 2002, improving the outlook for domestic corporate profitability. A recent survey by Ernst & Young indicated that the number of UK firms issuing profits warnings during the second quarter of 2002 had fallen to the lowest levels since the first three months of 2000.
This improvement was evident across all market sectors, with the exception of software. This gives us some confidence that UK companies will begin to report improved corporate profits in the second half of this year.
Reports released in recent months show US corporate profits are beginning to strengthen, as the impact of restructuring and downsizing gradually becomes evident. This improvement is expected to continue over the second half of 2002. In addition, the deadline for corporate executives to certify the accuracy of their reported financial statements passed without incident, although investors still remain wary of accounting irregularities.
Some observers have highlighted certain long-term trends for corporate bonds. Recent research by J P Morgan compared debt levels with the level of industrial production. The researchers noted that credit spreads and the rate at which companies default are closely related to the business cycle, and to the rate at which companies increase and decrease their levels of debt. Over the last five years, many companies took on considerable levels of debt to boost the return on their equities.
Over the next twelve months, companies should be emerging from a period of slowing earnings growth and should start to reduce debt levels, in particular short-term debt. We believe that the market is now at the point in time where debt is set to fall as profits start to grow and that corporate bonds' greater returns compared with gilts should protect investors against defaults.
The economic outlook expected by most observers is for interest rates and inflation to remain low in 2002, and for any rate rises in 2003 to be relatively modest.
This means that a stable return of 5-6% is likely to be attractive to both retail investors and pension funds. UK companies operating Defined Benefit pension schemes have recognised that FRS17 requires close attention. In the future, their liabilities will need to be more closely matched to bonds, which probably means increased investment in gilts and AAA-AA rated corporate bonds. Last year, the decision by Boots' pension fund to hugely increase its investments in bonds received much comment. Only recently, the Granada pension fund switched 25% of its fund from equities into bonds.
The supply of quality corporate bonds is likely to remain lower than demand. The UK government is likely to issue gilts, however this is unlikely to reach significant levels in the next quarter. The short-term volatility of equity markets may benefit the more defensive sectors such as utilities and food retailing.
However, as the economy improves and companies start to see their earnings grow, they will be able to reduce debt. This leads us to believe that the market currently offers a range of good opportunities for investors in quality corporate bonds.
The weakness of many companies' equity prices has also affected their corporate bonds.
Despite all the bad news, credit has still produced a positive contribution year to date relative to gilts.
Over the next 12 months, companies should be emerging from a period of slower earnings growth.
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