S&P Sees Strength, But Risks Ahead, In U.S. Corporate Bond Market - March 23, 2006
NEW YORK March 23, 2006--This year has started off on a fairly strong note for the U.S. corporate bond market, but risks are still seen ahead as the heady growth effect of the first quarter fades and the realities of slower economic growth and tighter monetary policy are felt more keenly, according to a report published today by Standard & Poor's Ratings Services. Although current credit conditions look remarkable, the report, which highlights salient developments in the U.S. corporate bond market and Standard & Poor's credit outlook for this asset class from a risk and return perspective, reiterates concerns about a gradual deterioration in credit quality, rising default rates, and widening spreads. Even so, the report, titled "Credit Outlook For U.S. Corporate Bonds," states that the situation ahead is unlikely to deteriorate significantly, suggesting that corporate bonds are likely to spend another lackluster year before facing up to more stressful conditions in 2007. In short, while Standard & Poor's near-term corporate credit outlook is somewhat ambivalent, its cautionary stance from a longer-term perspective remains. More specifically, the current status and outlook are as follows:
Credit quality presents a healthy profile, with 2006 upgrade activity outpacing downgrades. Other short-term metrics also provide little reason for alarm, but credit quality momentum still points downwards as GDP growth decelerates in 2006 and profits come under increasing pressure, which in turn increases the odds of future downgrades and defaults. Standard & Poor's macro forecast posits that first quarter real GDP growth will rebound towards 5.2% after sinking to 1.6% in the fourth quarter of 2005, but growth for the remaining quarters of 2006 is expected to move below trend, with 2007 growth falling to 2.5%. Slower growth has a more negative impact on the high-yield market, thus raising cautionary flags for this segment.
Bond issuance has been holding steady in 2006, with issuance more heavily focused in the 10-30 year segment, no doubt propelled by still relatively low long-term rates. Nonfinancial firms are expected to borrow more aggressively to finance expansion plans, since idle capacity is rapidly diminishing and the buffer offered by strong liquidity positions is likely to erode. Simultaneously, commercial paper issuance is likely to post strong gains as firms seek to augment lean inventory positions; the inventory-to-sales ratio fell to a series low of 1.24 in January 2006.
Firmer core CPI inflation--2.3% is forecasted for both 2006 and 2007--and worries about tighter global monetary conditions have been putting upward pressures on long-term yields. The market has been more reactive to the anticipated end of Japan's Zero Interest Rate Policy and eventual pressure on global liquidity. The Fed is expected to rest its case at a 5.0% Fed funds target, and continue to project that the 10-year Treasury yield--last seen at 4.70%--will soon cross the 5.0% mark.
Corporate bond yields have risen in tandem with Treasury yields. However, the bond market has been far less reactive than its Treasury counterpart, causing speculative-grade spreads to grind tighter this year, both in the cash and derivatives markets. Standard & Poor's expects that the slightly firmer core inflation tone, tighter monetary conditions, and a gradual increase in problem credits should drive speculative-grade spreads higher as risk perceptions increase. In addition, although the flat yield curve has severely compressed term premiums, rising long-term interest rates should cause these to widen out as well. Market contagion from the latest bankruptcy filing by auto parts manufacturer Dana Corp. was marginal outside the auto industry, suggesting that the market is fairly seasoned and immunized to negative news. The real test of indifference to negative news will come as the 2003-2005 surge in lower quality speculative-grade bond issuance ('B-' or lower) leads up to more credit events in the coming quarters.
From a total return perspective, although 2006 returns have shone for the high-yield universe, the upcoming phase of the credit cycle does not augur an improvement on this front. Flat returns are projected for investment-grade credits and slim 3%-4% gains from speculative-grade bonds, or lower than the returns obtainable from safe, short-term money market instruments.
Standard & Poor's study of trends for different industries suggests downside risks in cyclically sensitive industries in the consumer discretionary domain (automotive, consumer products, retail/restaurants, and media and entertainment), where pressures have been building. High energy prices and the expected slowdown in housing mar the consumer outlook in the near term, though the better hiring tone should help limit the damage. On balance, downside ratings activity could be concentrated in the telecommunications, automotive, and consumer products industries. On the plus side, industries poised to perform well include banks, transportation and health care.
"Although the risks inherent in the current corporate credit landscape are highlighted, we do not expect to see severe stresses develop this year," explained Diane Vazza, Managing Director and head of Standard & Poor's Global Fixed Income Research. Corporate America has managed to bring balance sheets to a high level of creditworthiness, and it is unlikely that such an improvement is likely to fizzle away quickly. The fourth quarter Flow of Funds data from the Federal Reserve Board showed healthy balance sheets with ample liquidity.
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