Corporate Bonds: Riskier Terrain in '07

The environment calls for some caution, including a defensive credit strategy and a wary approach to cyclically sensitive industries

As we step into 2007, it appears that corporate credit conditions in the first half of the year are likely to look similar to those of the last half of 2006. The expected soft landing and resilience of the corporate bond market to any negative news suggest we should see a continuation of the stable credit conditions that have persisted in the current Fed tightening cycle.

Ample global liquidity and the sense of market calm—as seen in low equity-market and interest-rate volatility—reveal a lack of credit worries, with investors willing to accept more risk to derive incremental yield. However, while the market has been complacent about risks relating to specific companies or particular situations, we still believe systemic risks are building up.

Pristine No More?

In particular, the prolonged macroeconomic slowdown should dent profits and raise the interest burden, which sets the stage for a riskier phase of the corporate credit cycle. We expect credit quality to gradually deteriorate from its current strong level and believe that the credit cycle's many facets—the downgrade cycle, the default cycle, and the cost and availability of funds—should navigate more testy waters during the second half of 2007.

With the Fed on the sidelines with a 5.25% fed funds target through mid-2007, the short end of the yield curve is unlikely to move substantially, while the continued strength of foreign inflows should hold down long-term interest rates. Even so, with the 10-year Treasury yield expected to meander up to 4.75% by mid-2007 and 4.95% by yearend, the risk-reward trade-off is likely to suffer. Thus far, credit risk has paid off, with high-yield bond returns through November at 10.55%, and high-grade bonds at a sizable 5.32%.

Slow growth is expected to dent corporate credit fundamentals from their current pristine state. We expect the interest burden to creep up as profits begin to look more pressured. While current credit metrics present a stable profile, with 2006 downgrades and upgrades matching the 2005 experience and the speculative grade default rate looking low at 1.33% in November, other leading credit quality measures continue to raise cautionary flags. One example: 25% of issuers currently have a negative outlook or CreditWatch status vs. 24% in January. We expect the speculative grade default rate to slowly climb toward 2.5% to 3% by late 2007.

Mortgages to Benefit

The high grade and speculative grade universe continues to bifurcate in credit quality, with 18% and 29% of issuers, respectively, having negative or negative-outlook ratings on CreditWatch. Net negative bias—the difference between negative and positive CreditWatch and outlook—is currently at 17.3% for the high-yield universe, higher than one year ago.

Strong corporate bond issuance of $886 billion for 2006 is beating the 2005 figure by 35%. While strong supply has been quickly absorbed by financial markets this year, the low payoff from taking increased risk is likely to hold back investor interest, particularly as the economy slows toward a 2.3% growth pace in 2007.

Bond market returns firmed across all fixed-income asset classes in November, building on their earlier gains. Through November, the riskiest asset classes remained the best performers. In addition, the low-volatility environment is aiding financial instruments that are sensitive to volatility, such as mortgages. In the corporate bond sphere, distressed debt has staged a strong 36.2% return, a sharp reversal from the -15.9% return seen in 2005. The overall high-yield market return is 10.55%, with investment grade debt fetching a sizable 5.32%.

Time for Defense

Low volatility and lower interest rates have helped increase total returns. However, with the 10-year Treasury yield expected to trend upward to 4.9% by yearend 2007 and 5.5% by yearend 2008, the 2006 gains will be difficult to replicate. Thus, despite the strong performance of high yield bonds, we remain concerned that returns could prove short-lived when interest rates commence on their path to normalization.

In an environment of rising interest rates, wider spreads, and slower economic growth, we expect corporate bonds returns to track a meeker 3% to 4% path in 2007. Thus, while the market's risk appetite may carry forward into 2007, this is likely to wane during the second half of the year amid falling credit quality and increasing default incidence. Hence, prudence requires the implementation of a progressively more defensive credit strategy during the next few quarters, such as lowering duration, maintaining a cautionary stance on lower-quality investments, and being wary of cyclically sensitive industries.

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