Tuesday, December 29, 2009

Apparently, corporate bonds aren't on a "sugar high"

Didn't Mark Kiesel of PIMCO get El-Erian's memo?

Credit Fundamentals Improving
Corporate credit fundamentals have improved with the return of private capital and management’s desire for less aggressive business and financial profiles. Rising cash balances, stronger balance sheets, an improving economy and easier credit conditions are all helping to support corporations....

This improvement in corporate credit fundamentals has materially improved the outlook for default risk, particularly in the high yield market, and increased balance sheet strength and financial flexibility for corporations. As a result, Standard & Poor’s is now upgrading more companies than it is downgrading (Chart 1).

Corporate executives’ confidence has increased with the improvements in balance sheets, credit availability and credit fundamentals, along with the gradual strengthening of the global economy. Nevertheless, management remains conservative on the outlook for sustainable economic growth, as government and monetary stimulus may fade throughout 2010. The longer-term economic outlook remains unclear, causing management to remain highly cautious about hiring and capital spending. This explains why companies are hoarding cash: According to JPMorgan, non-financial corporations, which from 2004–2008 held roughly $500 billion of cash on their balance sheets, increased their total cash holdings to $708 billion by the end of the third quarter of 2009. 

Although corporations remain conservatively managed, corporate profits are increasing with the moderate economic recovery (Chart 2). And, because hiring and capital spending are restrained, U.S. corporate free cash flow is improving significantly. As a result of cost cutting and aggressive expense control, non-financial corporations are now generating free cash flow equal to 29% of EBITDA (earnings before interest, taxes, depreciation and amortization), the highest level in a decade according to a December report from Goldman Sachs. In addition, corporate profits should continue to improve as credit conditions ease (Chart 3). A December global survey by McKinsey suggests that increased availability of credit is leading to a more bullish outlook and greater confidence in companies’ strategic planning and budgeting processes. If so, increased hiring and spending may be on the horizon, which could help improve the outlook for a sustainable economic recovery and a continued improvement in credit fundamentals.

The outlook for positive credit fundamentals is not without risks. The economy is highly dependant on monetary and fiscal stimulus, as both consumers and businesses are continuing to delever. Private sector final demand needs to strengthen before a sustainable recovery can establish itself. While near-term inflationary pressure appears under control, the Federal Reserve may have to tighten monetary policy should inflationary expectations rise. Aggressive Fed tightening would slow economic growth and be a negative for risk assets, including investment grade corporate bonds, high yield bonds and equities. Finally, the surge in cash on corporate balance sheets may be directed toward more shareholder-friendly initiatives such as increased dividends or share buybacks. Mergers and acquisitions (M&A) will likely rise in 2010, and bondholders will need to be on the lookout for management teams who appear likely to make changes to benefit shareholders.

Corporate Bond Market Technicals Supportive
Both financial and non-financial debt growth is now declining on a year-over-year basis, while the federal government’s debt growth is rising by 30% year-over-year (Chart 4). Non-financial corporates need less capital because cash on their balance sheets is rising: According to JPMorgan, their cash levels increased by $113 billion in the third quarter of 2009, as cash flow significantly exceeded capital spending. As the corporate sector delevers while the federal government re-levers, bond market technicals should increasingly turn positive for corporate bonds and negative for Treasuries. This will probably be the single largest factor in credit spreads tightening this year for a lot of companies.

Who’s buying Treasuries? Despite rising issuance, almost half of the increase in Treasury supply of $1.89 trillion over the past 12 months, or $889 billion, was purchased by non-U.S. investors. Will foreign investment continue to support the Treasury market to the same degree in 2010 in the face of rising issuance? The answer remains unclear, particularly given the low level of Treasury yields and upcoming surge in government borrowing...

Bank Bonds Likely to Be Winners in 2010
Within the credit market, the banking sector stands out as a likely winner. Banks should see a gradual slowing in the growth of problem loans as well as improving balance sheet strength and profit growth. Banks are delevering their balance sheets, raising more loss-absorbing equity capital and facing increasing regulatory oversight. In addition, bank and financial companies should benefit from reduced issuance needs in the bond market, providing for supportive market technicals. All these factors should support bondholders and lead to strong relative performance....