Last year we were happy to espouse additional exposure to corporate bonds as a way to enhance r...
Last year we were happy to espouse additional exposure to corporate bonds as a way to enhance return in an environment where yields on government bonds were becoming less than attractive. The view at the time was based on the relative cheapness of corporate bonds against government bonds, and our belief that the deflation scenario was not likely to materialise, and that the growth that was to follow was to be beneficial for corporate bonds.
As measured by the yield spread between corporate and government bonds, the view has paid off handsomely. However, it is time now to reconsider. With reference to the deflation scenario above, there can be no doubt that valuations have moved in favour of corporate bonds. In particular, those bonds that were worst off in 2002, namely high-yield, have performed best. In the universe of investment grade bonds, the poorer-rated instruments have as a rule led the performance rankings.
This stratification is quite significant. The market has given preference to those companies with the highest operational leverage and thus those where the potential profit turnaround in response to an economic upswing will be the most geared ' high risk, high return. This is not to say that low-risk corporate bonds have been a poor investment, it is just that the most performance has been generated by the very firms that were considered pariahs not so long ago. Good-quality corporate bonds have also performed better than government bonds.
Considering the current valuations of corporate bonds, especially the ones at the more risky end of the spectrum, there are some concerns. Whereas it was relatively easy a year ago to spot that the corporate market offered value, it is less easy to make that argument now. It is indeed the case that many companies have worked hard to reduce debts and rein in costs. This is good news for their bondholders.
Slimming down the balance sheet, however, comes at the cost of reduced capital expenditure, lower employment levels and so forth. Firms have been forced to sacrifice some internal growth potential in exchange for long-term financial survival. It is obvious that this strategy helps to reduce the risk profile in the short term.
Whether or not it is an optimal strategy to ensure profit growth is questionable. Thus, from a longer-term point of view, one has to be somewhat sceptical of the US corporate sector to generate solid profit growth with current levels of capital expenditure. What is needed is an incentive to start up the corporate spending engine and that spur would be economic growth.
There are two potential problems with this. First, even if economic growth returns in its pre-2000 form, there are still plenty of areas where companies still suffer from excess capacity. Nowhere is this more apparent than the auto industry. According to some estimates, excess capacity runs at 25% in the US auto sector. If true, this is problematic. No amount of economic expansion can generate enough demand to re-activate so much redundant capacity. More contraction would appear to be necessary. In the case of the big three, though, the process of contracting capacity does not necessarily reduce costs: due to the large pension fund deficits they have, Ford, GM and Chrysler are effectively adding to their pension liability by reducing workforce. So, contraction does not reduce costs very much, and carrying excess capacity is also expensive. What to do? Sell more cars?
That is proving an equally big challenge, considering the fact that many models are sold with 0% financing, and up to $4,000 in rebates and discounts are offered on premium models like Sports Utility Vehicles. We concede that the auto sector is a somewhat extreme example but it nonetheless has wider application is assessing the challenges facing corporate USA.
The second issue is whether economic growth will return in strong enough guise to lift companies out of the profit doldrums. While our central view is still that the Fed will avoid a deflationary spiral in the US, this is still not to say that the US will have another growth expansion of the late-90s type. Recent economic data have been a bit mixed, with something in it for everyone, from those espousing deflation to the optimists. In short, the jury is still out.
Considering this, and also considering the excellent run that corporate bonds have had, we feel the time is right for those who have been in this sector to take profits.
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