=DJ Fear Of Falling Prices Deflates Corp Bond Enthusiasm
10/14/2002
Dow Jones News Services
(Copyright © 2002 Dow Jones & Company, Inc.)
By Christine Richard
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)-Inflation may be the bond market's worst nightmare, but it's deflation that's keeping some corporate bond investors up at night.
While deflation increases the value of fixed coupon payments for investors, it also increases the burden on companies struggling to make fixed payments on their debt.
"Deflation eviscerates profits and aggravates liabilities," said John Rahill, a fixed income fund manager at Smith Affiliated Capital in New York.
That's why he's recommending a "deflation offensive" strategy for investors which includes high-quality fixed income instruments such as Treasurys but not many corporate bonds.
It's also why he isn't eager to buy the bonds issued by Ford Motor Credit Co., the financing unit of Ford Motor Co. (F), even though yield margins on those bonds are trading at around 500 to 600 basis points over Treasurys, a huge spread given Ford's investment-grade credit ratings.
Rahill is leery about the use of aggressive financing deals by all of the auto companies.
"Zero percent financing is just another way of saying price cuts," Rahill said.
Concerns about deflation also have John Cassady, fixed income fund manager at Fifth-Third Investment Advisors in Grand Rapids, Mich., cautious on the corporate bond market. He says deflationary concerns have been most evident in the telecommunications and auto sectors.
"The price of a one-minute long distance call has fallen from 25 cents a minute to 15 cents a minute to practically zero," said Cassady. "With free long distance on cellular phones, you could argue it has fallen to zero."
Combine falling prices with towering mountains of debt and the demise of numerous telecommunications companies doesn't come as a big surprise, Cassady said.
While the telecom sector may be experiencing the most extreme deflation, there's no doubt that deflationary pressures are lurking in other areas of the economy, including the service sector, he cautioned.
"It could explain why Treasury yields are so low," said Cassady, noting that those yields are trading at more than 30-year lows. "If you think that inflation is not is issue but deflation is, it could be that Treasurys are cheap at these levels," Cassady added.
Lower Prices/Lower Ratings
A lack of pricing power has been partly responsible for a number recent credit rating downgrades, according to John Lonski, chief economist at Moody's Investors Service.
For example, declining wholesale electricity prices have factored into many energy company rating cuts.
And, deflation is occurring throughout much of the economy, according to Lonski, who cited steady declines since late last year in the Department of Labor's core consumer goods prices data.
That core index, which excludes energy and food prices, declined 1.3% year-over-year in July, it's largest drop since the government began collecting the numbers in 1958.
The index hasn't declined for several months running since the early 1960's, according to Lonski.
Auto makers are facing an especially brutal pricing environment.
New vehicle prices have posted year-over-year declines every month since the beginning of March 2001. In August, prices on new vehicles fell 1.6% year-over-year while used vehicle prices dropped 2.9%.
There's no doubt, said Lonski, that a company's ability to raise prices improves its credit outlook while pricing pressures darken the outlook for a company's rating.
When credit rating upgrades were exceeding downgrades between 1994 and 1997, core consumer goods prices were inflating at an average annual rate of 1.5%, Lonski noted. During the same period, new vehicle prices were rising on average 2.2% a year, he added.
Bill Gross, who heads up the Pacific Investment Management Co. and runs the largest bond fund in the U.S., also has warned about deflation.
"Deflation combined with too much fixed rate debt can be an economy killer," Gross wrote in a research note earlier this month. That's because companies without pricing power can be overwhelmed by fixed debt payments, according to Gross.
"Debt and lack of pricing power is a dangerous combination," Gross wrote. "Gasoline and a match fall into the same category," he added.
-By Christine Richard; Dow Jones Newswires, 201 938-2189;
christine.richard@dowjones.com
(END) DOW JONES NEWS 10-14-02
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