While last year was a difficult one for corporate bond investors with unprecedented blow-ups and defaults, the arguments for holding a well-diversified portfolio of credits remain in place
For many investors in the sterling corporate bond market, 2002 was an annus horribilis. Along with corporate bond markets globally, the sector experienced an unprecedented number of disasters.
The worst case scenario for corporate bond investors is that a company defaults on its obligations to bondholders, failing to pay interest due and ultimately reneging on the capital repayment.
In 2002 there were a number of examples of this globally. According to the credit rating agency Standard and Poor's, the proportion of issuers defaulting last year was the highest since 1991. In addition, given the enormous size of some of the companies that failed last year the total value of bonds defaulted upon reached a record $157bn globally.
However, corporate bond disasters do not just take the form of defaults. Less severe, but still traumatic for investors were the blow-ups and fallen angels. Blow-up is a term used to describe any corporate bond that suffers significantly bad performance relative to the market. This often leads to the bond trading on a price basis rather than on a yield relative to the benchmark. This signifies that market participants view the bond's prospects as substantially independent from the overall bond market and therefore much more risky.
Fallen angels are those issuers whose credit ratings have fallen below the investment grade minimum category of BBB and into high yield (or junk) territory. Many investors are unable to hold bonds with ratings below investment grade and therefore become forced sellers should a ratings downgrade occur. This can often lead to substantial price falls.
According to a recent report from the Royal Bank of Scotland's fixed income research team, £14.5bn of sterling corporate bonds could be categorised as disasters last year, dwarfing the previous highest amount of £2.2 bn in 2001. Many of the issuers identified are household names, including Ford and Fiat in the auto sector, EMI and Carlton Communications in media as well as telecoms companies such as Cable and Wireless and Ericsson. The report breaks down the disasters in a number of interesting ways.
Although the financial sector led the way with the greatest number and value of problem bonds, the telecoms sector had the greatest density of disasters, with 47% of bonds in the sector affected. Given the massive borrowings taken out by telecoms companies over the last few years to expand networks and pay for third generation mobile phone licenses this is perhaps not surprising. Also somewhat predictable perhaps, given the robust nature of the UK economy relative to those overseas, was the breakdown by home country of the problem issuers. Non-UK parented issuers accounted for 74% of the disasters, with just 26% from domestic companies. Comparing these numbers against the fact that UK companies comprise about 75% of the Sterling corporate bond market highlights just how fragile the non UK issuer element has been. Also of note in the report was an analysis of the problem issues in terms of their launch date. The sterling corporate bond market has grown immensely over the last few years, with a substantial proportion of new bonds coming from non UK issuers.
Some of these more recent bond issues were more risky than they appeared at launch since between a half and two thirds of the problems last year came from bonds originally issued in 2000 to 2002.
So what lessons can corporate bond investors usefully draw from the blow-ups and defaults of last year?
Firstly, the sterling corporate bond market is becoming increasingly international and global credit research more vital. For the last two years, over 60% of new bond issuance has come from non UK companies. Although the purchase of some of these issues has been a traumatic experience for investors, this increasing internationalisation cannot be ignored.
Avoiding the disasters in the corporate bond market has been, and is likely to continue to be one of the primary determinants of good performance. In order to achieve this, an in-depth understanding of the company through comprehensive research is essential. With so many overseas issuers, thorough, ongoing research can be difficult for many domestically focused investors to achieve.
A well resourced global credit research platform is becoming increasingly valuable for fund managers as they seek to understand businesses domiciled away from the market in which they are investing. They need to meet with company management on a regular basis or, less importantly, to access the analysts of the ratings agencies who are usually based in the same location as the companies they cover.
The second lesson that can be drawn is the importance of portfolio diversification. Some of the problems that occurred last year were not predictable and however much analysis is carried out, it can be near impossible to identify instances of fraud. A diversified portfolio will limit any damage.
Most prudent portfolio managers employ strict concentration limits that constrain maximum exposure to a company dependent on its perceived risk, often as specified by its credit rating.
Third, a well diversified portfolio of high-quality corporate bonds should over the longer term more than adequately compensate an investor for taking credit risk. According to Standard and Poor's, the global default rate for investment grade bonds last year was 0.44%, the highest recorded. At the start of 2002, the Merrill Lynch Global Broad Market corporate bond Index yielded 1.21% in excess of equivalent government bonds, so that even in the worst year in history the yield compensation exceeded the greater risk.
Looking forward there are reasons for optimism that the disasters of 2002 will not be repeated in 2003. Standard and Poor's observes that default rates are already declining from their peak and are expected to fall further, though more slowly than was the case in the early 1990s, the last period of widespread corporate failure.
Part of the reason for the anticipated fall is that many of the more vulnerable companies have already defaulted so those that remain should be fitter and better able to survive.
In addition, there are some signs that companies are starting to address one of the major causes of the problems experienced over the last year or two ' excess borrowing.
During the boom years of the late 1990s, many companies increased their borrowing substantially, increasing productive capacity or buying back shares. A rise in gearing or leverage such as this is often bad news for bond investors, increasing the chance of default and therefore raising risk for bond holders.
The new reality of slower economic growth and a lower risk corporate culture has driven company managements to focus on improving cashflow, repairing balance sheets and reducing debt. This has already been seen in some parts of the telecoms sector with more reforms expected from some of the major European operators.
Much of this improvement has and will continue to take the form of reduced capital expenditure. It is hard, if not impossible, for companies to increase cashflow by raising prices when the economic background is one of slow growth and intense price competition. However, they can cut back on investment plans and, ultimately, if capital investment is below depreciation, capacity is reduced.
If this occurs throughout the corporate sector in aggregate, risks to bond holders fall and corporate bonds perform well. So far, the impact of this new bondholder friendly style of management is concentrated in a few sectors but it can be expected to spread as management focus on cashflow, constraining costs and debt reduction. Moreover, companies that do not follow the discipline can expect to be severely and rapidly punished by the markets.
Last year was a difficult one for many corporate bond investors with unprecedented defaults and blow-ups but the arguments for holding a diversified, well researched portfolio of corporate bonds remain. In addition some companies have begun the process of improving cashflow that will repair balance sheets and reduce risks for corporate bond investors.
Blow-ups and fallen angels as well as defaults have damaged corporate bonds.
Level of defaults should fall in 2003.
Overseas and telecoms were the most problematic sectors last year.
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