The only bond most of us find intriguing is the film operative James.
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But in the complex world of corporate risk and investment, bonds are without peer.
Corporate bonds are the lubricant that keeps the wheels of industry turning. Without the essential finance provided by corporate bonds, industry grinds to a standstill.
Corporate bonds are, in effect, IOU's that companies issue in exchange for cash. The borrowers are businesses of all kinds, from Macy's to Dr. Pepper to Rubbermaid. In terms of actual dollars involved, the corporate bond market dwarfs equities.
The reluctance of bondholders to exchange their debentures for stock formed the impetus that drove Chrysler into the waiting arms of the bankruptcy court.
How Downgrading Hurts
Like those issued by state and municipal governments, all bonds are rated. Bonds that carry a BBB from S&P or a Baa from Moody’s are rated investment grade. Any bond issuance below those ratings falls into “junk” status.
Companies whose credit-worthiness is reduced from investment grade to junk are known as “fallen angels.”
During the first quarter of this year, in the wake of some of the worst economic tidings in a generation, S&P downgraded 93 percent of the corporate bonds it rates.
Many corporations are getting downgraded in their credit quality because business is terrible. Their earnings are down, their profits are down, their revenues are down, and their ability to make these timely interest payments is deteriorating faster than the predictable plot of a typical Bond flick.
This diminished rating doesn’t mean that the downgraded business automatically will default on its debt obligations. Rather, downgrading puts a damper on the ability of these companies to borrow the funds they need to expand because with lower ratings businesses must payer higher returns to attract investors.
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The added expense associated with these lower ratings could lead to an additional round of layoffs and further slow the recovery of the economy.
For many of the companies whose ratings have fallen, their prospects for recovery remain grim. Although it may not drive them into bankruptcy, it makes them easy targets for takeover. Moreover, in the current environment, especially in light of the Chrysler bankruptcy, many corporate bondholders are now willing to sell their holdings at very deep discounts just to avoid a total loss of their investment.
While the corporate bond market may be reeling from a wave of bad news, sales of government-backed bonds have been brisk. In April, investors devoured more than 100 billion of government-backed bonds. These include Build America Bonds, taxable debt sold by municipalities and public agencies under the federally-subsidized program that was part of the economic stimulus package earlier this year.
As the economy begins to regain its footing, corporations likewise will turn to the bond market for liquidity, particularly given the current unwillingness of banks to extend their lines of credit. For the investor that understands the nature of the risk, the returns may be unprecedented.
Analyzing Realistically
During April, high-yield bonds returned an average of 11.5 percent. Despite their low ratings, some investors have seen these returns as a sign that the depths of the recession may have passed, encouraging them to begin taking on risky assets.
In the near term, further improvement in the corporate bond market likely will depend more on continued government intervention than on fundamental strength. Last month, for example, commercial mortgage-backed securities, or CMBS, rated AAA, returned 13.2 percent. Most bond analysts agree, however, that those gains stemmed largely from the government including the debt in the Fed’s Term Asset-backed Securities Loan Facility, or TALF.
Although the stock market may be staging a mini-rally, which has allowed it to offset some of the losses posted during the first quarter, the corporate bond market still has a long way to go.
Unless and until this aspect of the capital markets stabilizes, the prospects for reversing the trend of the current recession will remain elusive.
John Cohn is a senior partner in the Globe West Financial Group, based in West Los Angeles. He may be contacted at www.globewestfinancial.com
