The European bond markets have had a good first half, but the rest of 2009 may not be so kind.
First, the good news. Markets have done well as asset managers have pushed more money into corporate credit. They have been drawn by record high yields after Lehman’s failure, and also by the need to hunt down an alternative to low risk-free rates while avoiding volatile equity markets.
In spite of the gloomy outlook for defaults and the continuing drumbeat of rating downgrades, investors have taken progressively more risk as bond prices have risen, moving from defensive companies into more cyclical names, and even high-yield credits. This surge has allowed corporate bond spreads to narrow sharply even as companies have thrown a wall of paper at the markets.
These bond investors, whether intentionally or not, have become key players in global corporate finance. As banks rein in lending, companies need the public debt markets more than ever. With credit and funding in short supply, companies are cutting costs, slashing dividends and raising equity to preserve credit quality and keep their bondholders sweet.
The market has taken further encouragement from a series of better-than-expected company second-quarter results that has helped push spreads on the European investment-grade bond index back to pre-Lehman levels.
But a further leg-up from here looks unlikely, and for some companies, the most likely trajectory for bond prices will be down. While it is true that corporate earnings remain surprisingly strong, to the extent that this is due to restructuring and cost-cutting it is likely to prove finite. Meanwhile revenues, and net income, are falling sharply, eroding and in some cases eliminating free cash flow.
Corporate credit quality is therefore likely to deteriorate from here on in. Even though bond prices rose in the first half, the number of “fallen angels” — companies downgraded from investment-grade to high-yield — has been going up too. Two out of the top three months for downgrades to sub-investment grade on record were last month and in March, according to Standard & Poor’s. The ratings agency has identified a further 75 issuers globally with $255 billion of debt in danger of being consigned to junk status.
This has not been priced in by investors, especially at the high-yield end of the market. CDS prices for companies included in the iTraxx Crossover index of high-yield names suggests that the market expects lower default rates over the next year than the ratings agencies expect.
It could of course be that investors have a better idea of the true credit quality of corporate Europe than rating firms do. But the suspicion is that they are just being optimistic. And bondholders aren’t supposed to do optimism.