Glimmers of hope are surfacing that U.S. corporate bonds may snap their losing streak, but the market may need some help from equities before conditions truly begin to heal.
In May, corporate bonds suffered their worst pullback since the global credit crisis as debt troubles of European sovereigns soured the outlook for the global economy.
While the U.S. economy has not yet been shaken by Europe's woes, it could be if equities continue to falter.
However, stocks and corporate bonds could get a boost on resolution of U.S. regulatory reform issues, an improvement in the sovereign debt crisis or progress in containing the Gulf of Mexico oil spill.
"You just cannot expect the real economy to shrug off a sinking equity market indefinitely, especially given the fragile state of the U.S. financial system and the U.S. economic recovery," said John Lonski, chief economist at Moody's Investors Service.
"If we begin to notice financial market volatility gnawing away at real economic activity," the now low risk of a double dip recession will increase, he said.
The Dow Jones industrial average fell nearly 8 percent in May, its worst month in over a year, and has managed to claw back just a fraction of those losses in June.
During the week of the "flash crash" in early May, when the Dow Jones industrial average plunged 700 points in the space of minutes, corporate bond spreads widened by nearly 30 basis points, wiping out most of the year's tightening in spreads.
Corporate bonds do not necessarily trade in tandem with stocks, but they did in two of the last major market turns. After a major selloff in 2002, stocks and corporate bonds began rallying around mid-October that year, and both markets also began recovering from the global financial crisis in mid-March 2009 on the results of bank stress tests.
On a fundamental basis, corporate bonds should be performing better than they are. Defaults are plummeting and corporate earnings and cash flow are growing much faster than debt, according to Moody's.
But despite amassing large amounts of cash, companies are not hiring or spending as aggressively as would be expected, said Mark Kiesel, head of the corporate bond portfolio management group at bond fund giant Pimco.
"Regulatory reform, the sovereign debt crisis, the oil spill — all these issues are causing companies to kind of freeze up and not engage in the way they traditionally do," he said.
If equities continue to slump much beyond the month of July, the mood of businesses and consumers may worsen enough to change the outlook for the economy, said Lonski.
At least one major headwind, regulatory reform, could be resolved soon if congressional leaders meet their July 4 target date for passing the measure and having it signed into law, JPMorgan said in a research note on Tuesday.
More success by oil giant BP in mitigating its oil spill in the Gulf of Mexico could also improve sentiment, JPMorgan said.
President Barack Obama said on Tuesday that BP should capture up to 90 percent of the leaking oil in coming weeks, though high-end estimates of the spill rate were also increased to 35,000 to 60,000 barrels a day.
Even with all the uncertainties looming, some think corporate bond investors have turned too pessimistic.
"U.S. regulation is anti-growth, what's going on in Europe is anti-growth; longer term that's bad for economic fundamentals, it's bad for corporate America," said Bob Bishop, portfolio manager at SCM Advisors in San Francisco. "But for the short-term as a bondholder looking forward for the next month or two, I think spreads on some of these bonds are pretty attractive."
Though the outcome of financial regulatory reform is still unclear, its impacts may not be as bad for bondholders as many fear, he said.
Pending reforms will require banks to increase the quality and quantity of their capital, improve their liquidity and reduce business risks, he said. "In doing all that, it's going to make them a lot less profitable. It's a very bad outcome for shareholders; it's not a bad outcome for bondholders."
Kiesel also thinks the banking sector looks attractive.
Banks will be more conservatively run, relying more on traditional banking rather than proprietary and hedge-fund-like trading, he said. Large deposit-based banks like Bank of America will still have strong core earnings because of their ability to make more on lending relative to the near-zero percent rates they are paying on checking and savings deposits, he said.
Over the long term, the future looks good for corporate bonds, Kiesel said.
"You've seen a diversification move out of government bonds into credit and I think that secular move is only going to continue," he said.
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