How Will the Corporate Bond Market React?

The Economist explains to why corporate bonds should probably rally before a genuine rally in equities begins.

A further dilemma is whether corporate bonds will rally before equities. That would seem logical, given that bonds have a prior claim on corporate profits. In addition, companies seem likely to run their businesses for the benefit of bondholders rather than shareholders, cutting dividends to save cash, for example…there may be a selection problem: weak companies have tended to borrow, and there are very few AAA-rated companies these days. Many of the most heavily-geared companies are in the portfolios of private equity groups, rather than on the quoted market.

Nevertheless, it is hard to see how stock markets can find a bottom if corporate-bond spreads are still widening. In turn, it is hard to see corporate bonds stabilizing without a return to some kind of normality in the money markets, with banks and companies able to borrow freely again (albeit not quite as freely as they did in 2006). So, Libor is the key to a market bottom.

Explaining the point that corporate bonds should see a rally before a real move upwards in equities a CLSA report explains:

It is unrealistic to expect any rally in equities without there first being a rally in corporate bonds. At the four great bottoms, the price of BAA corporate credit rose before the price of equities rose.

In 1948, bond and equity markets were distorted by government caps on treasury yields and excess-profit tax on corporate profits.

Source: Business Week

Source: CLSA

However one has to wait and see how the corporate bond market responds to poor earnings and cash flow reports over the next two quarters. Surprises may call for downgrades and the corporate bond market may reassess the risks again and price them in. This obviously would be negative for equities.

Disclosure: No positions.

Comments

[shootpar2001:]

History is a guide of course, and today's crisis just has a few more zeros attached at the end. However, that added weight may just take longer to work off than in the past. A recession that lasts 2-3 years may be what the doctor (marketplace) orders.

A slow and steady exercise of the debt excess' will provide for a healthier economy and markets.

DISCLOSURERS: Nibbling at credit risk: (PSY), (DHF), (ACG).

Jan 11 11:55 AM

[jepittman:]

I find it hard to swallow that six months will go by before corporate spreads narrow. There is a ton of money making very nearly nothing in short term securities. Money supply is going parabolic and people know it. Ultimately that money is going to take those yields. We are seeing it now. LQD is back to pre-Lehman levels. Even junk bonds have rallied smartly since the Fed meeting in mid December.

It may take six months to FULLY normalize but spreads will be much narrower in three. Just MHO.

Jan 11 04:58 PM

[Stock Marke...:]

I agree, with libor coming down, hickups along the way, it is only a matter of time before spreads come back into a normal range. Once money starts to slowly flow, it usually picks up steam.

Jan 25 08:09 PM