Capital Markets

Unsavory Spread

The market for corporate bonds is struggling again.
Economist StaffMarch 13, 2009

Ten years ago Warren Buffett and Jack Welch were among the most admired businessmen in the world. Emerging markets were seen as risky, to be avoided by the cautious. But now the credit-default swaps market indicates that Berkshire Hathaway, run by Mr. Buffett, is more likely to default on its debt than Vietnam. GE Capital, the finance arm of the group formerly run by Mr. Welch, is a worse credit risk than Russia and on March 12th Standard & Poor’s downgraded its debt-the first time GE and its subsidiaries have lost their AAA rating in over five decades.

The contrast highlights the sorry state of the corporate-bond market. A turn-of-the-year rally was founded on hopes that spreads (the excess of corporate-bond yields over risk-free rates) more than compensated investors for the economic outlook. That has now petered out.

The weakness has been much greater in speculative, or high-yield, bonds than in the investment-grade part of the market. This is hardly surprising. First, economic prospects are so dire that companies already in trouble will have difficulty surviving. Banks are trying to preserve their own capital and do not need to own any more toxic debt. Even if refinancing were available for endangered firms, it would be prohibitively dear. It is only a matter of time before some go under.

Moody’s cites 283 companies at greatest risk of default, including well-known outfits like Blockbuster, a video-rental chain, and MGM Mirage, a casino group. A year ago just 157 companies made the list. Standard & Poor’s says 35 have defaulted this year, against 12 in the same period in 2008. That translates into a default rate over the past 12 months of just 3.8%.

The rate is likely to increase sharply. Charles Himmelberg, a credit strategist at Goldman Sachs, forecasts that 14 percent of high-yield bonds will default this year, with the same proportion going phut in 2010. Worse, creditors will get back only about 12.5 cents on the dollar. All told, Goldman thinks the combination of defaults and low recovery rates will cost bondholders 37 cents on the dollar in the next five years.

A second problem for the corporate-bond market is that optimism about the scope for an imminent end to the financial crisis has dissipated. “People have given up hope that the new [Obama] administration will be able to do anything to make things better quickly,” says Willem Sels, a credit strategist at Dresdner Kleinwort.

Banks are still the subject of heightened concern. Credit Derivatives Research has devised a counterparty-risk index, based on the cost of insuring against default of 15 large banks; the index is now higher than it was after the collapse of Lehman Brothers. Jeff Rosenberg, head of credit strategy at Bank of America Securities Merrill Lynch, says investors are uncertain about the impact of government intervention in banks. Each successive rescue, from Bear Stearns to Citigroup, has affected different parts of the capital structure in different ways.

A third problem for the high-yield market is that plans for quantitative easing (purchases by the central bank of government and private-sector debt) are focused on investment-grade bonds. As well as reviving the economy, governments are concerned about protecting taxpayers’ money, and so will not want to buy bonds at high risk of default. If the government is going to support the investment-grade market, investors have an incentive to steer their portfolios in that direction.

The relative strength of the investment-grade market even permitted the issuance of around $300 billion of bonds in the first two months of the year, albeit largely for companies in safe industries such as pharmaceuticals. Circumstances suited all the market participants. “Spreads were wide, which attracted investors, but absolute levels of interest rates were low, which suited issuers,” says Mr. Rosenberg.

Although the Dow Jones Industrial Average jumped by nearly 6 percent on March 10th, it is hard to see how the equity market can enjoy a sustained rebound while corporate-bond spreads are still widening. Bondholders have a prior claim on a company’s assets; if they are not going to be paid in full, then shareholders will not get a look-in. However, credit investors say their market often takes its lead from equities. If each is following the other, that hints at a worrying downward spiral.