Corporate Bond Picture Brightening
GRAND RAPIDS — The last interest-rate cut made by the Federal Reserve Board should be one of a handful of factors that will help interest investors in the corporate debt market.
Certainly, the six-month outlook for short-term corporate notes and long-term bonds is a rosier one than the market’s recent history.
“We had a real rough 1999. We had spreads winding out, corporate securities under-performing, and risk-free treasuries due to investor perceptions of a slowing economy — correctly as it proved out to be,” said Mitch Stapley, chief fixed-income officer at Lyon Street Asset Management Co.
A slowing economy causes investors in the corporate debt market to fret about potential defaults due to weakening balance sheets, a worry not found in the T-Bill market. That shift put some pressure on corporate securities.
But this year’s stock tumble drove some investors to the debt market, which held more security for them than either the NYSE or Nasdaq could offer.
“The spreads right now are to levels that are basically discounting a far worse case scenario than we were probably facing. So what happened was investors went to those extremes, they looked and said, ‘At least I’m being compensated for it.’ So corporates, up until Sept. 10, were having a really, really good year,” said Stapley.
“Until then, it was the best-performing class of the investment-grade markets. These were doing better than the Treasury market was, better than agencies were, and better than mortgages were,” he added.
Of course, the terrorist attacks changed everything, including the corporate debt market. Stapley said since Sept. 11 the market has surrendered much of the out-performance it once had, in relation to the risk-free securities. But, as he pointed out, the change has also created new opportunities in the market, most notably for those investors who can focus on the next six months instead of the next six days.
“Treasury yields have declined dramatically over the course of the month, especially on the short end of the curve. For corporate bonds, the yields have actually gone up to reflect renewed investor concerns about a slowing in the economy,” he said.
And investors drive the market. If a company wants to go to market, it needs to contact an underwriter to learn what yield it will have to offer in order to attract investors. That yield is set above the rate paid by a corresponding treasury security to compensate for the added risk an investor assumes for buying corporate debt.
The difference in the yield between a corporate and treasury security is called the spread, which is laid out in basis points. A hundred basis points equals one percentage point. So if a firm prices its 5-year note at 150 basis points over the going rate of a 5-year T-bill that pays 4.5 percent, the company will pay a yield of 6 percent to lure investors away from T-bills.
“There will be periods like in 1997 and 1998 where corporate spreads were very narrow because the economy was just humming along — 5 percent growth and low inflation with companies making money hand-over-fist. Then the perceived risk of company securities is much lower,” said Stapley.
Today, however, investors have a harsher perception of risk and return. Companies now may have to offer another 100 basis points or more over what they would have offered during the good times, just to get investors to consider their offerings.
“The firm is basically at the market’s whim as to whether they can come to market,” said Stapley.
The spread a company must offer to investors is largely determined by what it does and when it makes its offering.
“If you were coming into the airline industry right now, you would have a very hard time raising unsecured debt. Bad headlines. Bad everything. But if you wanted to come to market and you were a defense electronics maker, you’re probably going to be able to find a very receptive pool of investment dollars out there. Timing is absolutely huge in this.”
The Fed cuts should keep the yield curve steep and lending costs down. Other steps that the federal government took also should pump up the economy and provide investors with incentives to take a long, hard look at the corporate debt market between now and spring.
“Forty billion dollars in emergency appropriations on top of the $80 billion that is going to be hitting next year through lower withholdings. The $60 billion that is in the pipeline this year from the rebates and the lower withholdings we’re seeing this year,” said Stapley.
“This is old-fashioned Keynesian economics. It will be successful and the economy will come back. So we’re probably facing the economy coming back quicker than we might have thought, say, two months ago — hard as that is to believe right now,” he added. “ But there is an enormous amount of stimulus in the pipeline, and that will be good for corporate bonds.”