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Corporate Benefits

The outlook for corporate bonds is much brighter than it was only two months ago. Since the start of December, spreads on corporate bonds have narrowed significantly from levels not seen since the Russian debt crisis.

This is a reflection of the changing macro-economic environment, particularly in the US. In late November, the Federal funds rate was 6.5 per cent, business and consumer confidence was falling and the US presidential election had not been decided. This picture has changed dramatically.

Despite evidence that the US economy continues to weaken, the financial markets are indicating that the bulk of this may already be priced in. In January, Alan Greenspan cut rates by 100 basis points, indicating that the Federal Reserve will do all it can to avoid a hard landing for the economy.

The Fed&#39s rate cuts and statements encouraged the belief that even if there is an economic downturn, it will be mild and that the extreme risk aversion that had predominated for much of the fourth quarter might have been overdone.

US government long-bond yields have backed up, corporate bonds have rallied, corporate issuance has resumed and high-yield spreads have reversed most of November&#39s dramatic collapse.

While these developments will not continue in a straight line, it is likely to require significantly worse than currently expected economic news to turn the general trend around and for credit spreads to widen out to new cycle highs. Further steepening of the yield curve is likely.

The promise of tax cuts by President Bush will also assist a soft landing.

Consequently, business and consumer confidence has and will continue to pick up gradually but this will be moderated by continued concern over companies missing targets, as highlighted by Cisco&#39s recent numbers.

Europe has also benefited from an improvement in sentiment in the US and from a strengthening euro. Together with volatility in equity markets, the weakness of the euro contributed to significant underperformance of the European high-yield market in 2000 compared with the US and UK. The weakening dollar may concern some but it was probably overbought towards its peak last year. In the UK, the 25-basis-point cut in the base rate by the Bank of England should help to bolster business sentiment which has been affected by the doubts surrounding a soft landing in the US.

From a market perspective, the environment has also improved since November. Net flows into US mutual funds for the past two months and fewer new issues have combined to reverse somewhat the scenario which blighted most of last year, that is, excess supply. Already this year, a number of new issues have got off the ground.

The improving macro-economic and market environment for high-yield bonds led euro-denominated bonds to outperform both their sterling and dollar counterparts. For the two months to the end of January, the Chase euro-denominated high-yield index produced a total return of 14.7 per cent compared with the equivalent sterling and dollar indices returning 11.2 per cent and 8 per cent respectively.

Although these kinds of returns are ones that could be expected on an annual basis, let alone over two months, there is still potential for reasonable performance for the rest of the year. Europe appears to be the most attractive market while there is still room for the euro to strengthen further. In addition, although the US economy should soft-land, the European economy may be the stronger on a global basis.

Changing technical factors in the UK may also benefit the double A and triple A rated credits. If the minimum funding requirement is changed radically, as suggested by the recently published Myners Report, pension fund managers will choose to increase their exposure to corporate bonds at the expense of gilts.

Overall, the environment for corporate bonds has much improved compared with late last year. With the prospect of interesting new issues coming to the market and continuing pricing anomalies in the secondary market, 2001 should be a challenging, interesting and particularly rewarding year for corporate bonds.


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