U.S. Corporate Bond Market – Uncertain Times

By Scott B. MacDonald

We remain constructive about the rest of the year for the corporate bond market, though there are many uncertainties - the possibility of another terrorist attack, the potential for a U.S. war against Iraq, and a double-dip recession. Another al-Qaeda terrorist attack on U.S. soil would be a blow to confidence, while it is difficult to quantify the impact of a U.S. war against Iraq. A double-dip recession would obviously be a big negative. Although we do not rule out a double dip recession, we expect the U.S. economy to muddle through. The combination of auto sales, mortgage refinancing, and housing, plus one more Fed interest rate cut, will allow the economy to slide by at around 2.5% for 2002. That stated, we still expect investors to remain very sensitive to any negative news on the economy and to remain focused on corporate earnings (in late September and October for Q3). The equity market will continue to be exceedingly volatile, with seismic-like daily shifts.

Much depends on restoring investor confidence. In August, when we enjoyed a short-lived equity market rally, the corporate bond market saw spread tightening and new issuance. During the third week of August, 28 issuers came forward and brought $16.36 billion in bonds to market, the largest weekly number since March 2002’s $26.9 billion. While some economic numbers helped nudge the rally, there was also a sense of relief that most major companies made it through the August 14th CEO and CFO earnings accountability signings without major problems. Indeed, the corporate governance issue, barring any new scandals, is likely to fade as a concern.

It is estimated that potential new investment grade corporate bond issuance for the remaining months of 2002 could be between $90-$100 billion, at least part of which comes from the need to refinance as debt comes due. The next major trigger for the corporate bond market is likely to be Q3 corporate earnings, which start in late September. As corporate governance issues fade, attention will return to more fundamental credit concerns about profitability, debt management, and liquidity. Related to this is the pace of the economy. Most economists are looking for real GDP growth in Q3 in excess of 3%, followed a slower pace in Q4. That could help provide some traction for better corporate earnings through the end of the year. However, there remains considerable nervousness in corporate America and most managers are still looking to trim capital spending -- not increase it. The earnings announcements of the large brokerages, such as Morgan Stanley, thus far have not set a positive tone. JPMorgan Chase’s problems, including ratings downgrades, have not helped.

It should also be understood that the drop in U.S. unemployment from 5.9% to 5.7% was largely due to job creation in government, while manufacturing actual had a drop in employment. As we see consumer demand remaining in positive territory, the most likely outcome is that the economy on a whole will not get much worse, but it will not get much better. The same can be said for the corporate bond market.