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The engine falters

The sun, moon and stars were in near-perfect alignment last year for creditworthy companies interested in tapping the bond market. A series of Federal Reserve Board interest rate cuts rendered financing inexpensive and encouraged investors to believe an economic recovery was imminent, boosting tolerance for credit risk. Corporations with investment-grade ratings sold a record $571 billion in bonds during 2001, according to New York market-data company Dealogic.

The sun, moon and stars were in near-perfect alignment last year for creditworthy companies interested in tapping the bond market. A series of Federal Reserve Board interest rate cuts rendered financing inexpensive and encouraged investors to believe an economic recovery was imminent, boosting tolerance for credit risk. Corporations with investment-grade ratings sold a record $571 billion in bonds during 2001, according to New York market-data company Dealogic.

The underwriting fees associated with that issuance were one of the few bright spots for Wall Street firms. More significantly, the healthy bond market kept the wheels of corporate America turning as the stock market careened and banks cut back on commercial lending.

But the conditions that contributed to a free flow of bond deals may be over. Despite the lowest Treasury rates since the 1950s, investment-grade companies sold only $64.5 billion in new bonds during the third quarter of 2002 (through September 19), off 45 percent from the second quarter and 63 percent from the first (see graph). In July investors bought only $10.7 billion in high-grade corporate bonds, making it the worst month in nearly five years. Deals pulled included $1.6 billion from Pepco Holdings, $225 million from Illinois Power Co. and $160 million from Mobile Storage Group -- all canceled or postponed due to what analysts call "market conditions."

Why the skittishness? Investors have been burned by blowups of investment-grade companies during the past year. From Enron Corp. last fall to WorldCom in June, the growing list of fallen angels has reminded investors that investment-grade ratings aren't guarantees against default. "There's an awful lot of fear out there," says James Prusko, a senior portfolio manager at Putnam Investments. "In July, after WorldCom, the market just vapor locked. There was an incredibly high aversion to risk."

Other factors are at work. Last year a host of commercial paper rating downgrades shut companies out of that market and prompted them to "term out" those debts by issuing longer-dated bonds. The commercial paper outstanding for nonfinancial companies has dropped 15 percent from $1.63 trillion in November 2000, according to J.P. Morgan. But now most of the conversions are done.

Issuance in 2001 also benefited from the tail end of a capital expenditure boom, especially among telecommunications companies. Many of the companies that gorged on debt have defaulted and entered bankruptcy. The result: Another source of deal flow has vanished.

A number of observers project a multiyear cycle of corporate deleveraging, the extent of which will mirror the heavy borrowing of the late 1990s. "It's the Malthusian theory in action," says William Cunningham, J.P. Morgan's chief credit strategist. "Companies are running out of food. They binged too much, and there's nothing left for them to take in. It would have happened last year if not for the Fed; thus it's happening now."

Activity has picked up a bit since July, but investors remain selective. The companies that can get deals done -- generally, infrequent issuers with low debt overhangs -- are finding very attractive terms. For example, Coca-Cola Co. raised $500 million in seven-year bonds on September 4. And IBM Corp. sold $600 million in seven-year securities plus $1.1 billion in two-year notes the next day. Both companies paid only 88 basis points above comparable U.S. Treasury securities on their seven-year bonds, and IBM paid just 12.5 basis points above Treasuries on the two-year tranche.

"There are a lot of people out there who need to buy corporate debt," says Putnam's Prusko. "But the market is bifurcated into names that people are scared to death of on the one hand and those that you have tons of demand for on the other."

There is some hope that corporations will soon be able to raise capital in the bond market at something approaching normal levels. But a return to the giddy capital raising of 2001 isn't likely in the near future.

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