Where The Rate Cut Is Really Working Its Magic

The across-the-board rally in the corporate bond market bodes well for the economy as a whole

Federal Reserve Chairman Alan Greenspan's emergency interest-rate cut is having more impact than it might seem. True, the stock market is wringing its hands, but the corporate bond market is giving the Jan. 3 move a thumbs-up. Companies have come back into the market and found buyers for their bonds. Credit spreads--the additional interest yield over U.S. Treasuries that investors demand for the risk of lending to corporations--have come down, an encouraging change in direction from their rise in 2000. Spreads have improved across the market. For some key investment-grade issues, they're down as much as 0.2 percentage point to a 1.6-point spread. The improvement spans industry sectors and bond maturities. Spreads on high-yield junk bonds, issues judged below investment grade by rating services, are down by 0.47 percentage point to 8.61, according to Merrill Lynch & Co.

The improvement in corporates is key to keeping the markets open for companies that need to raise investment capital. This is vital to the economy. Greenspan, in a Dec. 5 speech paving the way for cutting rates, cited the risk that the markets and lenders would be too restrictive. Confidence in the corporate bond market should encourage stock investors as well as bank officials who are deciding whether and to what degree to participate in loan syndicates.

LURKING DOUBTS. The move signals bond investors' inclination to believe that the Fed's medicine will keep the economy from recession--despite whatever ailments prompted Greenspan to act. "The Fed is out there working for us. They've got to save the real economy," says James Swanson, who manages $2 billion in bonds at MFS Investment Management.

Although doubts persist about how quickly the medicine might work, "the market voted," says Peter Milhaupt, a managing director at Credit Suisse First Boston who markets corporate debt issues. "We've had a tremendous rally across all industry sectors in the investment-grade arena."

Brisk sales of new issues show the rally is real, even if young. In the second week of January, Citigroup sold $5 billion worth of debt, twice what was originally anticipated, says Milhaupt. Meanwhile, the yield spread on Citigroup bonds had narrowed from about 1.88 percentage points over Treasuries to 1.6, adds Brad Tank, fixed-income director at Strong Funds.

Now, DaimlerChrysler has come to market to sell more than $4 billion worth of bonds denominated in dollars, euros, and pounds. That's a change from December, when the issue was rumored but never materialized, notes Tank.

PICKY. Indeed, as Greenspan cut rates, the first week of January saw the sale of $6 billion of investment-grade corporates, with an additional $14 billion lined up for the second week, says Milhaupt. By contrast, in the period shortly after Thanksgiving, bond issues had slowed to about $4 billion a week from a pace of about $10 billion.

In the junk-bond market, buyers are being more picky and shunning companies with virtually no cash flow. They are still smarting from the junk market's worst year in a decade. Despite interest coupons of 8.4%, total returns in 2000 worked out to a loss of 5.1% on Merrill Lynch's high-yield index. The yield to maturity at yearend was 13.9%.

A big reason for the trouble in the junk-bond market last year was the decline in prices for stocks of telecom startups, says Kingman Penniman, president of KDP Investment Advisors Inc., a high-yield research firm. Telecom issues make up almost 20% of the $267 billion market of public issues. Without the prospect of more stock issues to raise the additional money needed to build out fledgling wireless and local networks, telecom bonds sank to distress levels, foretelling a rise in defaults.

Although many telecom issues are still being left for dead, other sectors of the junk market have perked up. Well-established cable company Charter Communications Inc. sold $1.75 billion worth of bonds on Jan. 5, twice as much as originally planned. The Charter sale alone amounts to half as much as the total $3.3 billion junk debt issued the final three months of 2000, by Penniman's count. "The last three months' issuance was almost nonexistent," he says. That so little debt was being sold is amazing, because junk investors collect more than $3 billion a month in interest alone, not to mention repayments of matured bonds.

Corporate markets were so quiet around Thanksgiving that it was hard to find anyone to trade with, says Swanson of MFS. Whereas he had easily been able to trade $10 million worth of bonds earlier in the year, buying even $500,000 worth from dealer inventories became an accomplishment.

Wall Street dealers "weren't willing to position either way," says Swanson. The finger-pointing goes the other direction, too: Milhaupt says portfolio managers chose to pile up cash near the end of the year rather than take new risks in the declining market.

To be sure, part of the revival in corporate issues is a seasonal effect. Late in every year, fund managers and Wall Street dealers back away from risks to protect their performance for the year. In the investment-grade market, there were unusually good results from 2000 to shelter. The total return for the year on Merrill Lynch's corporate master index was 9.14%. But the more important change stems from the spreading view that creditworthiness will improve from here with the Fed's support for the economy.

CLOUDY. In the future, additional improvements in the corporate markets probably won't come easily--or benefit all companies. For one, the junk market still needs a clear reversal in the trend of net redemptions from junk-bond mutual funds. There were reports of a slight net inflow the first week of January, but that was against net redemptions in all but one of the last dozen weeks of 2000. "We've got to get that turned around," says Martin S. Fridson, chief high-yield strategist at Merrill Lynch. Only companies with reliable cash flow, such as cable outfits, can raise money now. "Any industrial, chemical, telecom, or company with any taint cannot finance in this market," says Swanson. Still, the Charter bond sale shows investors do have a taste for bonds of the more creditworthy companies.

Even investment-grade fund managers are leery of holding issues that a fragile economy may suddenly deliver to the headlines of failure, says Swanson. The risk has been driven home by the declines in creditworthiness at Xerox Corp. and Finova Group Inc., for example. "There is a lot of career risk" in holding vulnerable issues, he says.

The big issue is the remaining fear about the economy. "There are people who are still scared" about recession and increasing defaults, says Penniman. They're looking for confidence that the economy will soon be improving. With Greenspan hinting he'll keep cutting, that reassurance may be as near as the Fed's next meeting on Jan. 30 and 31.

Before it's here, it's on the Bloomberg Terminal.