The past six weeks have been fairly volatile for the U.S. corporate bond market, with riskier segments coming under heavier pressure. Yields and credit spreads have been tossing and turning on higher core inflation and geopolitical concerns. Temporary aberrations notwithstanding, we detect enough early warning signals in corporate credit metrics to continue our cautionary stance on the sector, particularly for the high yield segment.
A series of ugly core CPI inflation readings have raised inflation concerns and with central banks across the globe aiming to mop up excess liquidity, the standard prognosis holds: Economic growth should slow, dragging down profits and credit quality, thus exposing the deficiencies of the weakest issuers and elevating default rates. We expect that repeated volatility episodes will continue to dent the bond market's psyche, pushing spreads wider for riskier credits to more balanced tradeoff levels.
We remain concerned about a gradual deterioration in credit quality. With real GDP growth slowing to a below-trend 2.6% rate in the second half and into 2007, speculative-grade credit quality is likely to take a bigger and more visible hit, particularly since high yield issuers have been entering the bond-borrowing arena in greater force.
Thus, we expect to see a widening credit divergence between the high yield and high-grade market, since companies in the latter segment have larger cash cushions to weather any liquidity squeeze. We expect the 12-month speculative-grade default rate to rise to 2.5% by yearend from 1.7% rate seen in June, with a further trek upward to 4.0% by yearend 2007.
If the Fed rests its case at a 5.5% fed funds target by August, we could see a small relief rally in financial markets. While the Fed Chairman's recent testimony and the Beige Book release were somewhat calming, we expect that liquidity conditions should tighten perceptibly, with key central banks across the globe in a synchronized tightening mode. Already, swap spreads have moved up in the face of an inverted Treasury yield curve which is typically associated with tighter lending conditions and declines in credit quality.
With benchmark yields in major countries creeping up, an orderly decline in risk appetite should emerge, which augurs an increase in corporate bond yields and wider spreads, holding down bond market returns in the process. The risk is that a vicious cycle could take hold, particularly since firmer core CPI inflation—we forecast 2.5% for 2006 and 2.4% for 2007—will dent real returns and also keep Fed uncertainty in play.
Supply metrics and the shareholder-friendly philosophy infiltrating corporate boardrooms is another bond market negative. Bond issuance has been running strong thus far in 2006, spurred on by the continued strength of share-buyback activity, along with vigorous M&A activity and leveraged buyout financing. Nonfinancial firms will likely need to borrow more aggressively to finance expansion plans, replace aging capital, and stay competitive.
While we see mixed readings in the current credit environment, our expectation is that the negative features will slowly gain more traction, denting the longer-run credit outlook. Negative elements in the current credit environment include the economic slowdown underway alongside stronger inflation, the liquidity drainage in progress from the Fed and other major central banks, and the prospect of higher long-term interest rates.
On the positive front, corporate credit fundamentals look sound, with strong earnings growth and profitability, coupled with healthy balance-sheet positions. However, companies have been buying back their stocks at a rapid clip and recent reports suggest that debt issuance is being increasingly deployed for stock repurchases and raising dividends. Such actions increase leverage without increasing bond repayment abilities, further marring the credit quality outlook.
In view of our expectations of rising interest rates, wider spreads, and slower economic growth, we expect that corporate bonds returns are likely to come under renewed pressure. Thus, to reiterate the theme from prior sections, until valuations adjust, it would be prudent to maintain a defensive credit strategy during the next few quarters.