CreditSights: Looking Back At Q1
The first quarter is now behind us and, it must be said, the performance from the corporate sector during the quarter has been disappointing. In our view, the most notable change in the corporate bond market during the last three months has been the loss of risk appetite that has seen an end to the high-beta compression trade and resulted in the sector being able to deliver only a minimal level of outperformance versus the Treasury market.
The change is evidenced in the primary market in volumes that are well down on last year's levels. Although the reduced supply levels have been cited as a reason to be constructive on the market's performance prospects (the rationale being that continued strong redemptions and coupon payments lead to a low level of net issuance and hence are supportive for the technical base and limit spread pressure), we do not view the restrained primary market activity as a net positive.
Historically, the corporate sector has delivered some of its period of best performance at times when issuance was particularly strong (2001 and 2003). Alternatively, volumes drop precipitously whenever spreads are impacted by an exogenous shock. While that is not the case currently, the low primary market volumes are having an impact on investor's ability to trade.
The secondary market in corporate bonds remains very concentrated. The top 10 issuers regularly account for over 30% of the turnover and the top 20 account for approximately 50%. This means that investors are very restricted in their ability to restructure their portfolios and change sector weightings through secondary market trading.
When primary volumes drop then the constraints are felt even more keenly, leaving the market with little end-investor sponsorship and increasing the focus on those sectors that act as liquidity proxies. It is not surprising that the auto sector has been singled out for such concentrated selling as the market has been looking to reduce exposure against such a background.
On the demand side the most-notable trend in the quarter has been the shift in mutual fund flows. As equity funds gather an outsize share of new money, high yield fixed income funds have seen a complete reversal of fortune. The strong inflows of the fourth quarter have been replaced by a heavy volume of net outflow. Although these have tapered off in recent weeks, our analysis of historic flows suggests that they will not quickly reverse as investor demand has been hampered by the lack of perceived value in the sector. And our first look at foreign demand levels for 2004 suggests that this is not just a domestic phenomenon. Foreign purchase fell sharply in January and we expect to see the next round of data confirm that the weakness continued throughout the quarter.
One trend that is in its more nascent stage is the latest round of merger and acquisition activity. Volumes here are growing rapidly, at a pace even quicker than our expectation. We maintain our view that the M&A trend is largely a benign one for bondholders and continue to believe that correctly handicapping participants in coming consolidation rounds is likely to have a significant impact on portfolio returns. However, some of the bidding activity that was seen in the last three months has led is to be a little less sanguine on the degree of prudence that will be exercised as the trend heats up. It may well be the case that management teams have forgotten the lessons of 2002 more quickly than bondholders are likely to.
