Big borrowers benefit from best bond market in 15 years
By Terence Flanagan
Bloomberg News
12/27/2003
NEW YORK — As a growing economy boosted confidence in the ability of companies to repay debt, borrowers such as Ford Motor Co. and General Motors Corp. benefited from the best year for U.S. corporate bonds in at least 15 years.
And forecasts for economic growth suggest that demand might increase, keeping the premium investors demand near five-year lows in 2004.
The extra yield, or spread, investors demand to hold investment-grade company bonds rather than U.S. Treasury securities has shrunk by almost half to 95 basis points on average from 185 basis points a year ago, according to Merrill Lynch & Co. data. A basis point is 0.01 percentage point.
"The default rate has dropped dramatically, and the economy is gaining traction," said Barbara McKenna, head of investment-grade strategy in Boston for State Street Research & Management, which oversees $27 billion of bonds. "It's been the perfect recovery" for corporate debt.
The preference for higher-yielding debt over Treasuries helped to generate a return of 8.7 percent, including interest payments. General Motors sold $13.5 billion in June after Moody's Investors Service cut its rating one level to BBB. The issue was the largest U.S. debt sale and the third-biggest globally, ranking behind $16.4 billion by France Telecom SA in 2001 offering and $14.5 billion by Deutsche Telekom AG in 2000.
Next year, the economy might expand at a 4.4 percent pace, the best since 1997, according to the median estimate of 62 economists surveyed by Bloomberg News. In 1997, yields on corporate debt averaged 60 basis points more than Treasuries.
"Credit spreads should continue to tighten" if economic growth takes hold next year, said Thomas Connolly, co-head of credit capital markets at Goldman Sachs Group Inc. in New York.
Demand, as measured by the spread over Treasuries, rallied the most since Merrill Lynch began tracking the data in 1987. Spreads on Ford debt, the most widely held corporate bond, narrowed even after Standard & Poor's in November cut its credit rating one level to BBB-, the lowest level of investment grade.
Overall, companies issued $640 billion of investment-grade debt this year, up 17 percent from 2002. The sales were $28 billion less than in 2001, said Raj Dhanda, co-head of global debt syndicate in New York at Morgan Stanley, the fourth-biggest company bond underwriter. Issuance in 2001 is the highest on record, according to the CreditSights Inc. research firm.
The yield on the 10-year U.S. note, a base rate for corporate borrowing, averaged 3.98 percent in 2004, compared with 5.88 percent over the last decade. The yield touched 3.07 percent June 16, the lowest level in 45 years.
"That was serendipity," Steven Fisher, treasurer of Science Applications International Corp., said about the timing of the company's $300 million debt sale that day.
The closely held information technology company, based in San Diego, sold debt rated A3 by Moody's and A- by S&P, in the middle tier of investment grade.
Uptick in mergers
Sales in the United States rose this year, but net issuance, which excludes debt sold to replace maturing bonds or bonds being bought back, was little changed at $275 billion, Dhanda said.
For a second year, companies haven't boosted net debt in an effort to repair balance sheets after the collapse in 2002 of companies such as Enron Corp. and WorldCom Inc. On July 21, 2002, WorldCom filed for bankruptcy protection, the largest such filing in U.S. history, as it struggled with $35 billion of debt. The filing came 14 months after the company sold $11.9 billion of bonds — at the time, the third-biggest U.S. corporate debt sale.
Net debt exceeded earnings before interest, taxes, depreciation and amortization by 1.6 times in 2003, down from 1.9 times in 2002, according to Merrill Lynch. AT&T Corp. and Comcast Corp. have reduced debt. Ford and General Motors are among companies that have sold fewer new bonds.
Sales of new debt probably will rise "modestly" in 2004, perhaps by 5 percent to 10 percent, driven partly by borrowing to expand, Dhanda said. "Merger and acquisition activity is bound to pick up at least somewhat."
Improved earnings
This was the first year since 1999 that company debt without investment-grade ratings outperformed securities with lower default risk. High-yield, high-risk bonds — those rated below Baa3 by Moody's or below BBB- by S&P — have surged 28 percent this year, on average, the biggest gain since 1991, according to Merrill Lynch.
Returns on junk bonds are more than double the 11.9 percent gain for bonds rated BBB, the lowest tier of investment grade, Merrill Lynch data shows. Company debt rated A or better, including securities sold by borrowers such as General Electric Co. and Citigroup Inc., is up 6.1 percent this year.
By contrast, Treasuries have gained 2.7 percent this year.
Because corporate-bond returns trounced those of safer government debt, investors had only to be right on 50 percent of their picks to have a "great" year, McKenna said. It might take a success rate of 75 percent or 80 percent to achieve the same result in 2004, she said.
Investment-grade company debt rose 10 percent or more, including price gains and interest payments, in each of the last three years. During that time, junk bonds fell 2.7 percent.
"We're starting to see continued improvement in the earnings picture," said Frederick Hoff, manager of the $2.8 billion Fidelity High Income Fund in Boston.
Profit of companies in the S&P 500 index is on pace to increase 16.8 percent this year and 12.4 percent in 2004, according to Thomson Financial.
Rising earnings typically boost junk bonds most, because increased cash flow helps to lift lower-rated companies' credit quality quicker. The annual default rate in November fell to 5.3 percent from 8.4 percent a year ago.
Demand for lower-rated debt was buoyed by a lack of high-profile defaults this year.
"There were a lot of sins to pay for, and a lot of that has been cleaned up," Hoff said.
Low yields on government and investment-grade corporate bonds have pushed some investors to increase returns with riskier debt. Some insurance companies and pension funds have boosted junk-bond holdings to 8 percent to 10 percent from a typical 5 percent, said Linda Carter, who helps to manage $4.4 billion of high-yield bonds at Eaton Vance Management in Boston.
Holding more junk bonds worked this year, but by 2005 or 2006, it might be a different story, some experts said. Some investors might "run into trouble as a result of accumulating high-risk, default-prone securities," said David Goldman, head of global market research at Bank of America Corp. in New York. |
