Trillion dollar confusion

In the same week that corporate bond issuance reached record levels, the number of corporate bond defaults also hit historic highs. Are we set for a credit market correction?

‘Corporate bond issuance hits new record’ ran the headlines on Wednesday. On Thursday however we were reading ‘Corporate bond defaults hit record.’ If you’re confused by news emanating from credit markets, don’t worry because you’re not alone.

Earlier in the week, data firm Dealogic reported that global corporate bond issuance had hit $US1 trillion for the year, the first time it had done so. With banks reluctant to lend and bond funds eager to invest at bargain levels, the result was a boom in bond issuance.

The volume and performance of corporate bonds masks the fact that 2009 is the worst year on record for bond defaults as 201 borrowers, with $US453 billion of debt, have hit a wall. The numbers look nasty but have, to a large extent, been priced in while restored confidence in the credit sector is allowing companies to re-finance, slowing the default count ticker.

It has however been a week of mixed signals as credit reached an ‘inflection point’.

Investors and traders are asking if the reversal in credit spread tightening is a sign of a healthy pullback or a precursor to a return of the bear market.

And it’s not only dealers who are debating but entire asset classes, with equity and credit markets agreeing to disagree. While stocks bounced back emphatically from a poor start to the week, credit indices have underperformed, trending lower.

There are a number of reasonable explanations for the disconnect. For starters, credit’s rally has been fiercer and faster than any in its history. Its current weakness may be reflecting a more profound correction relative to equities.

Another premise may be that credit markets tend to focus on suppressed economic fundamentals such as consumer spending, while equities have taken heart from what appears to be an improving corporate profit outlook.

It’s a natural bias given credit’s real gains from an economic revival are moderate compared to stocks, and the varying macro-economic views as to the shape of the recovery may be at play, resulting in divergent investment decisions by debt and equity investors.

There is a more elementary reason to explain why credit and equity markets move out of sync, however. It’s the classic conflict of interest between owners and lenders.

During the darker days of the crunch, credit and equity were in the trenches together, and both sets of investors demanded hasty deleverage.

But as the darkness lifts, the dilutive capital raisings have left shareholders with a smaller piece of a lower yielding pie. For bond investors, especially in investment grade corporates, the legacy of the credit crunch is a positive one.

This week’s set of corporate earnings highlighted the trend. Investment grade corporates such as Rio Tinto, Wesfarmers, Santos and the AREITS told investors that massive equity issues, dividend reductions and asset sales had significantly reduced their debt burdens.

But the leverage clock never stops ticking. As the environment stabilises, companies are once again seeking to appease their stockholders. This week saw a number of equity ‘deals’ with growth rather than capital management a motivating factor. There are also rumblings of some IPOs on the way, marking what would be the final stage of the recovery of our capital markets.

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