A deceleration in downgrades, low interest rates, an improving economic and financial environment and declining corporate spreads helped fuel a positive year in high-grade corporate bonds. In fact, the performance was more than positive, it was almost unprecedented. "We've had one of the largest moves in terms of spread tightening in almost a decade," according to Mark Pibl, head of U.S. high grade research at Barclays Capital. Average bond spreads were 250 basis points over Treasuries last January and had narrowed to as low as 100 over Treasuries late in the year, Pibl estimates. Some sectors, such as autos and utilities, were as high as 500 basis points over last January and had halved going into the end of December. Pibl attributes the tightening to the strengthening of corporate balance sheets through equity offerings and improved liquidity through debt refinancings. "We think that the improving economy will continue to strengthen credit fundamentals by keeping corporate bond spreads tight," he says, adding that any backup in interest rates will be mitigated by improvements in credit fundamentals.
Joe Labriola, head of investment grade research at BNP Paribas, points to the decline in downgrades as another major theme for the year. The ratio of downgrades relative to upgrades began to improve at the start of the year and the number of upgrades increased during the second half of the year. Overall, roughly 74% of all corporate rating actions were downgrades this year, compared to almost 82% in 2002, according to Standard & Poor's. Labriola also notes lower default rates and improved credit quality on both the commercial and consumer sides as highlights says those factors go hand-in-hand with an improving economy. Furthermore, technicals provided a healthy backdrop. He says total new issuance has been flat or 10% less than last year's total, which was $538 billion, according to S&P. That, in turn, was 21% lower compared to 2001's tally.
Jim Fields, portfolio manager at Wright Investors Services in Milford, Conn., notes the lowest-rated bonds within investment grade have driven the market. Triple-A bonds accounted for 3.3% in returns, compared to an 11% gain generated by triple-B securities, according to the Lehman Brothers Aggregate Bond Index. He says investors have taken on more risk as the economy has improved and corporations have taken advantage of the lower levels in rates by coming to market now to fund at low yields. Fields adds these movements in the market were a result of friendly changes to tax law and lower interest rates, both of which spurred the economy.
