Corporate bonds' recent winning streak could soon be coming to an end.
With investors fixated on the possibility of the U.S. losing its stellar credit rating, they may be missing another danger lurking in the fixed-income market, say experts: More corporate bonds could be headed for downgrades of their own.
While corporate bonds saw a record low number of downgrades and defaults in the second quarter, some analysts say that winning streak may be coming to an end. This comes at a time when income-starved investors have been flocking to corporate bonds for their relatively healthy yields. Investors have poured $42 billion into corporate bond funds so far this year, following inflows of $106 billion in 2010, according to fund researcher Lipper. "The crystal ball is a little foggy as we go into next year," says James Dailey, portfolio manager of the Team Asset Strategy fund (TEAMX). "Credit conditions could deteriorate."
Market watchers point to signs that the corporate bond market could be headed for a rough patch. Downgrades and defaults rise when corporate debts outpace profits -- a scenario that's becoming more likely as economic growth remains sluggish, says John Lonski, a chief economist at Moody's Analytics. And with unemployment hovering at above 9%, consumers may further cut back on spending, squeezing corporate profits even more and making it more difficult for companies to issue new bonds. "It's not exactly alarming yet but things are moving in the wrong direction," says Lonski. "If it continues we could be staring at a credit cycle slump and with that more downgrades and credit defaults."
For investors, an increase in downgrades would make corporate bonds less attractive. Investors who own bonds from downgraded companies would likely see losses as yields come up and prices drop, says Diane Vazza, head of Standard & Poor's Global Fixed Income Research. Even a downgrade from BBB to BB would be significant, adds Vazza, increasing yields by 2 percentage points. In fact, yields on junk bonds are already edging up, and now pay 5.51 percentage points above comparable Treasurys, up from a low of 4.57 percentage points in April. Investment grade bonds now pay 1.73 percentage points above Treasurys, up from a low of 1.6 percentage points. "The market is perceiving there is more risk and wants to be compensated," says Vazza.
To be sure, the corporate bond market is healthier now than it's been in the past. The number of companies at risk for downgrades fell to 451 in June, less than half of the peak in April 2009, according to Vazza. And so far, second quarter earnings have been strong, says Lonski, which has boosted stocks left many companies in good shape to continue their bond payments. On top of that, the economy may still pick up in the second half of the year, which would reduce the likelihood of defaults or downgrades, says Krishna Memani, director of fixed income for Oppenheimer Funds. "Our outlook is that by the end of the summer we'll get out of the soft patch," says Memani.
In the meantime, skittish investors should stick to higher-quality bonds because lower-rated issues are most likely to get downgraded first, says Dailey. Some money managers are scaling back on corporate bonds altogether until the economy picks up. Wilmer Stith, portfolio manager of the MTB Intermediate-Term Bond fund (ARIFX) has cut back the funds corporate bond exposure to roughly 45% from 75% in March. "I need to see improvements in the economy, I need to see improvements in business conditions before we ramp up that allocation," Stith says.
For investors, an increase in downgrades would make corporate bonds less attractive. Investors who own bonds from downgraded companies would likely see losses as yields come up and prices drop, says Diane Vazza, head of Standard & Poor's Global Fixed Income Research. Even a downgrade from BBB to BB would be significant, adds Vazza, increasing yields by 2 percentage points. In fact, yields on junk bonds are already edging up, and now pay 5.51 percentage points above comparable Treasurys, up from a low of 4.57 percentage points in April. Investment grade bonds now pay 1.73 percentage points above Treasurys, up from a low of 1.6 percentage points. "The market is perceiving there is more risk and wants to be compensated," says Vazza.
To be sure, the corporate bond market is healthier now than it's been in the past. The number of companies at risk for downgrades fell to 451 in June, less than half of the peak in April 2009, according to Vazza. And so far, second quarter earnings have been strong, says Lonski, which has boosted stocks left many companies in good shape to continue their bond payments. On top of that, the economy may still pick up in the second half of the year, which would reduce the likelihood of defaults or downgrades, says Krishna Memani, director of fixed income for Oppenheimer Funds. "Our outlook is that by the end of the summer we'll get out of the soft patch," says Memani.
In the meantime, skittish investors should stick to higher-quality bonds because lower-rated issues are most likely to get downgraded first, says Dailey. Some money managers are scaling back on corporate bonds altogether until the economy picks up. Wilmer Stith, portfolio manager of the MTB Intermediate-Term Bond fund (ARIFX) has cut back the funds corporate bond exposure to roughly 45% from 75% in March. "I need to see improvements in the economy, I need to see improvements in business conditions before we ramp up that allocation," Stith says.
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