NEW YORK, July 27 (IFR) - A U.S. sovereign downgrade is likely to drive down yields on U.S. investment grade corporate bonds, as wary investors snap up these cash-rich credits and the government deals with its own messy balance sheet.
The looming downgrade has some investors rethinking the composition of their portfolios, and while there’s no pressing need yet to make major changes, the safer bets are beginning to emerge.
“I think a downgrade would have an impact more on the equity markets than on the debt markets,” said Bill Larkin, fixed-income portfolio manager at Cabot Money Management. “In the longer run after a downgrade, people are going to be more conservative, more risk averse. That could create a deflationary environment, which is a positive for bonds, not for equities.”
That’s not to say that a downgrade by any of the three major rating agencies would immediately take away the safe-haven status of Treasury bonds. In fact, those highly liquid securities could rally as a result.
However, a U.S. sovereign downgrade scenario has highlighted for many investors the comparably stellar earnings performance — and balance sheet strength — of U.S. corporations, making the corporate bond market (excluding financials) the go-to place for portfolio managers to get a safe pick-up over Treasuries.
“We’re not doing a whole lot differently <ahead of a potential downgrade>,” said Tom Murphy, portfolio manager at Columbia Management in Minneapolis. “We’re reducing our sensitivity to interest rates, but one thing that’s been lost in all this is how strong corporate earnings have been.
“Net income growth is about 20% for those in the S&P (excluding financials) that have reported. The best place to be right now is corporate bonds. Of course you have to pick your spots, and where we’re not generally investing is financials.”
Analysts, too, recognize the strength of corporations, excluding financials. A Moody’s report released earlier Wednesday noted that U.S. non-financial corporate cash holdings increased to $1.24trillion at the end of 2010 from $1.11trillion a year before, an 11.2% increase.
The report highlights how well diversified corporations’ revenue streams are — nearly half of the cash holdings reside overseas.
That has been a positive for bond investors and has given them a chance to own quality names like Microsoft (MSFT.O), Cisco Systems (CSCO.O), Pfizer (PFE.N) and Google (GOOG.O), which along with Apple (AAPL.O), held the largest amount of cash according to the report.
Despite huge cash piles, Microsoft, Cisco, and Google raised cash in the bond market this year to the tune of $9.25 billion combined, in part to repatriate some of that cash otherwise trapped abroad. Pfizer hasn’t been in the market since 2009, and Apple has never raised money in the bond market.
What’s more, despite an increase in shareholder-friendly activity, such as stock buybacks, increased dividends, and M&A — typically the bane of bondholders — investment-grade corporations are still rolling in cash. In short, corporate balance sheets are in order — and the government’s is not.
“Despite $483 billion of new bond issuance in 2010, the corporate debt-cash ratio (3.06x) is at its lowest since 2006 as companies use new proceeds to retire old debt,” according to Moody’s.
As a result, investors are expected to pay more attention to these cash-rich corporations in the event of a downgrade.
“I think all corporates should trade tighter,” Murphy said. “It will highlight the poor state of US finances against the quite strong corporate balance sheets.”
Still, a downgrade of the U.S. sovereign would create an anomaly for certain corporate investors. A handful of U.S. companies, those four remaining Triple A corporate borrowers, would have a credit rating higher than the U.S..
That creates a tricky situation. Investment grade corporations in the US use Treasury securities as a benchmark against which they price their own fixed-rate corporate bonds.
Should a downgrade occur, outstanding bonds issued by Microsoft, Exxon Mobil (XOM.N) and Johnson & Johnson (JNJ.N) — three of the four Triple A corporate issuers — could trade tighter than Treasuries. Automatic Data Processing ADP.N, the other AAA rated credit, had no senior unsecured debt outstanding.
The U.S. has nearly $10 trillion in Treasuries outstanding, whereas the Triple A industrial corporate name have in the 10s of billions of dollars of debt outstanding. It isn’t much in comparison.
But what might be viewed as a shift to a country where corporations trade tighter than the sovereign is already happening. The CDS on the U.S. sovereign was quoted on Tuesday at 59bp, after closing Monday at 57bp. Those levels are significantly wider than the 40.5bp quote on Microsoft, the 41bp level on J&J and Exxon’s 30.3bp level, also on Tuesday.
The effect on Triple A corporations will likely be limited.
“I don’t think in response to a U.S. downgrade that people are necessarily going to pile into Triple A companies,” said Murphy. “People don’t just buy things based on ratings alone - liquidity’s very important. People buy Treasuries for liquidity more so than for ratings.”
What’s more, investors might be turned off by the new, ultra-low spreads.
“We would likely sell those issues and reinvest in other higher-yielding corporate sectors,” said John Bender, head of U.S. fixed income at Legal & General Investment Management America.
Timothy Sifert is a senior IFR reporter