If you equity investors think you've got it tough, consider us bond guys. Finding a triple A rated U.S. industrial, utility or bank bond worth buying is about as easy as finding Sasquatch. You'd think that it would be an easy exercise, given the corporate bond market size: It represents, roughly, a sixth of the market value of the world's bonds.
Why is it so tough? There are a number of reasons, from the weak corporate balance sheets to the influx of foreign bond buyers to the government's reduced issuance of Treasuries. Oh, and don't forget that there are fewer market makers now, too.
Despite the great returns generated by most sectors of the investment-grade corporate bond market in recent years, there has been a disturbing underlying trend that most investors have ignored: the decline of corporate credit quality. Over most of the 1990s, credit spreads tightened to historic lows, but the ratio of bond rating downgrades by Moody's and Standard & Poor's rose by a factor of 10 by the close of 2001. (Of course, the downgrades were collateral damage from the Asian Contagion, the Long-Term Capital Management implosion and the Russian debt debacle.)
That notwithstanding, investors need to be aware that there have been structural changes and these are reflected in the bond market's major indices. According to the Lehman Brothers Credit Index, it is clear that high-quality corporate bonds are a dying breed and that riskier BBB securities are becoming dominant in the U.S. corporate bond market. (By the way, the definition of the S&P's BBB or Moody's Baa ratings is adequate in the short run, but perhaps unreliable over the long term.) In fact, the lower half (from A to BBB rated) of the market now represents nearly 75 percent of the Lehman Credit Index. The Merrill Lynch AAA Corporate Bond Index has likewise been affected: The number of issues in the index has declined from 549 in 1988 to just 85 by yearend 2001. Moreover, the number of U.S. domestic corporations that carry the much-heralded Aaa or AAA bond credit rating within this Merrill index has dwindled to just six.
If your clients have traditionally restricted themselves to the high-quality sectors of the corporate market, you will find slim pickings. Indeed, the six Aaa/AAA members of the Merrill index are: Bristol — Meyers Squibb, General Electric, Johnson & Johnson, Merck, Pfizer and Exxon-Mobil. Unfortunately, most investors' portfolio investment guidelines have not come to grips with these facts.
In view of this trend, the rise in the number of BBB-rated issues used to create the Merrill Lynch and high yield indices comes as no surprise. In fact, the number of issues in the BBB Index are likely to grow further, especially given the potential downgrades among the single A issues that are currently on negative watch.
Therefore, we expect the divide between the high-grade corporate bond market and the lower grades to widen in the coming months. High grades will be expensive and stay expensive and the B-rated and lower will continue to fall. A two-tiered market is developing, and volatility reigns. Paper of companies such as Tyco, under scrutiny for accounting shenanigans, can fluctuate by 100 basis points on bad news days.
Brokers, therefore, will need to update their client investment policies to reflect these market conditions. In general, we think you should expect less in returns from your high-quality corporate bond investments going forward. Therefore, investors will be increasingly forced to consider lower-quality alternatives for return, which brings added risk of default. If investors gain a better understanding of the risks associated with these structural and credit risk changes in the U.S. bond market, they will inevitably be better prepared to meet the challenges they present.
Robert G. Smith III is president and CIO of Sage Advisory Services, the Austin-based fixed income manager.