Stephen Wilson-Smith, head of credit research at M&G Investments in London, gives his outlook for corporate bonds.
This year has been positive for bondholders. There has been a lot of natural deleveraging in the industrial and telecoms sectors and a big reduction in debt that started in 2003 and has continued this year.
Companies are cutting costs and improving cashflow and we are near record levels of corporate profitability, which is not so much due to revenue growth but to cost reductions and greater efficiency.
What is more, there has been a continued decline in default rates, making bonds a safer investment. However, that has been more than reflected in their price as bond spreads have tightened massively.
The equity market has been punishing companies that have made big acquisitions and there is more pressure on them to focus on their core competencies. That has been clear in the number of companies that have sold non-core assets or made bolt-on acquisitions to strengthen the business they already have.
Pressure from shareholders for greater returns, has driven an increase in dividends and share buybacks. But this trend has not risen to a level that threatens companies' credit ratings.
Companies have largely fixed their balance sheets and there is no need to carry on deleveraging unless they are looking to be upgraded ? but we do not expect companies to releverage in a large way either.
There is an increase in private equity activity and that has pushed up the leverage on deals financed with high yield bonds.
One area of concern is event risk, when there is the perception that a firm is not well managed. That risk could rise with the firepower private equity houses have at their disposal.
This is why it is important to push for covenants in investment grade corporate bonds.
We saw the danger with the potential acquisition of M&S ? if it had gone through the company would have been seven or eight times leveraged. There was no protection in the bonds and they would not have had to be bought back.
Investors who have been short corporate bonds this year have not done very well, but it is hard to make the valuation call. Corporate profitability is rising, defaults are low, so there is room for spread tightening but it is increasingly important to be selective.
It is difficult to assume technicals will change dramatically in 2005. However, if you are not too bearish on growth then firms will need money to invest, and not all firms will fulfill their refinancing needs with cashflow, so there will be ongoing needs for public bonds.