The Daily Interview: What a Flight to Quality Means for Bond Investors

As we move toward the end of the first week of trading since last Tuesday's terrorist attacks, the jitters and concerns about both the weakening economy and security continue to consume the market.

Louise Purtle Corporate Bond Strategist, Deutsche Bank

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Today's Daily Interview checks in with Louise Purtle, U.S. High Grade Corporate Strategist for Deutsche Bank, to see how she is now assessing the bond market in light of last week's events. In general, Purtle is counseling caution in this period of what she calls "unprecedented uncertainty." Pending any military action the U.S. government may undertake, she foresees strong, medium-term pressure on bonds and equities alike, and anticipates that the Fed will cut short-term rates even further.

TSC: Could you give us sketches of the corporate bond market before and after the terrorist attacks last week? How do you see the demand-and-supply situation evolving in the short and longer term?

Purtle: At the beginning of July, we had scaled back our asset allocation recommendation on corporate bonds from overweight to neutral. At the time, we felt that these levels fully priced in the economic outlook, expectations of which were being revised down even at that point. We also noted that investors had been increasing their allocation in credit all year long.

Post last Tuesday's tragedy, the whole picture has changed, and we have issued an immediate underweight recommendation on the sector, because we see medium-term pressure on the sector for the following reasons:

First, the economic outlook has become much more negative. If there was a debate raging prior to Sept. 11 as to whether or not we were actually in recession, there is certainly no argument about it now. The hit to consumer confidence from the attacks will exacerbate an already steep fall that we had seen before last Tuesday. It will be further compounded by layoffs -- just look at the airline announcements -- and the sense of uncertainty that will take hold as the military response gets underway. Consumer-sensitive sectors including autos, nonfood retailers and apparel manufacturers will be most affected. These expectations are already being played out in the initial ratings actions we have seen this week.

Second, equity market volatility will increase, and despite the relatively subdued reaction of the last two days, we believe the market will further weaken as the full extent of the economic impact begins to unfold. Beyond the direct impact of falling equity prices, bondholders are further at risk from the increased level of share buybacks being authorized under the SEC exemptions to foster stability in the equity market. Erosion of balance-sheet strength and the subjugation of bondholder interests to equity holders are significant concerns.

Third, we are already seeing the impact of last Tuesday's physical destruction: a severe decline in air travel and the disruption of events across the country. Losses in the insurance and airline sectors are the first and most obvious effect, but you also need to factor in disruption to sales in stores, damage to telecommunications infrastructure, etc.

Now we'll see more risk-aversion trade. Last Tuesday will become a defining point for our generation, as it ripped away our sense of invulnerability and illuminated a new, powerful and very real enemy. Vulnerability and uncertainty create defensiveness and this will compound a bias towards flight to quality in investment behavior. We expect lower-rated credits will be punished as widespread credit upgrade trades take place.

TSC: You anticipate a flight to quality and safety. Does that mean that you see a rally in U.S. treasuries while corporate bonds will suffer?

Purtle: That is already playing out. We have already seen big moves in the Treasury curve. Be careful here because while there is flight to relatively safer high-quality assets, U.S. Treasuries are not the only high-quality asset that's out there. There are [other] agencies such as FannieMae and FreddieMac. Even within corporate bonds themselves, there are triple A-rated companies such as GE (GE).

So when we talk about flight to quality, that doesn't mean everybody will buy Treasuries, but that people ought to raise the level of quality of their exposure to credit. That might mean someone with a single A-rated auto company moving to triple A-rated GE, or some people selling triple A's and buying [government] agencies. So remember that flight to quality can take on different layers.

TSC: What does the surprise half-point cut mean in your corporate strategy going forward? What are you advising your clients to do right now?

Purtle: The first comment I would make about the 50 basis-point cut is that it wasn't that much of a surprise. We continue to highlight to investors that last week's events were unprecedented and therefore should not be viewed in terms of previous market dislocations and the reactions they have generated. Given that the attack was both on Wall Street and on America's sense of security, the successful functioning of our capital markets is a key weapon to fighting this new war. Therefore, investors should expect more active use of all the means at the disposal of the governing bodies.

TSC: Do you anticipate further cuts by the Fed? If so, how soon?

Purtle: Our economics department has forecast that there's likely to be another cut of 25 or 50 basis points at the upcoming Fed meeting on Oct. 2.

Regarding how helpful the Fed's moves are, you have to look at the totality of the situation now. The Fed, I believe, will do everything in its power to stabilize the markets and promote economic growth. We'll see further stimulus from the government beyond the $40 billion [emergency package], which has already been pledged at the President's proposal. Also, a month or two down the track, we need to ask: Have we taken any military action? Has there been positive or negative global response to such action? And how does such an action potentially affect our oil supply?

These are some of the issues that will greatly matter to the overall economic picture. We just went to war, and we can't fight a war with monetary policy alone.

TSC: What are the things you look for in yield curves? Why is a steepening yield curve, which you anticipate from the further interest-rate cuts, important?

Purtle: At the front end of the curve, the yield is usually set by the expectation for what the fed funds rate is going to be. At the long end, the yield is set by the anticipated inflation and the U.S. Treasury supply. We saw a big steepening in the yield curve in anticipation that the Fed will cut rates to add liquidity and stabilize the markets. People think the Fed will continue to cut rates if necessary and the market is pre-empting that. Up until now, the government has been buying back Treasuries in order to absorb some of the excess supply in the market. This surplus has now dried up and this is pushing up expectations at the long end of the yield curve.

This does two things to the credit markets: One, the steep yield curves economically are very good news. All of the financial institutions make money by borrowing short and lending long, which means that they borrow your cash money, invest it in the bank and lend you on a 30-year mortgage. It means that the margin, they get increases and it capitalizes the banking system, which becomes more willing to make loans to businesses and promote growth. So traditionally the yield curve that is most supportive for economic growth is a very steep curve. And from the credit perspective, people want to be in credits when they see that economic growth is increasing and corporate profits are rising. Here we have a slightly different situation because we have an unprecedented level of low interest rates.

TSC: What kind of sector strength and weakness do you anticipate in the bond market?

Purtle: We see as the most negative sectors airlines, insurers, autos, nonfood retailers and brokers and investment banks. The most positive sectors are defense, energy and noncyclical consumer companies such as supermarkets and health care.

Longer term, we expect the events of last week will end the significant erosion in technology investment we have seen this year as new security, defense, communications applications are developed to accommodate the era of new commercial practices into which we will be ushered. Medium term, this will help the telecom and technology sectors, but near-term they are at risk given their triple-B and lower credit rating levels. Basic industries are at risk from the much slower growth and are also exposed to any sustained increase in energy prices from current levels. REITs -- though perhaps not the REITs in New York -- look like a good defensive play.

A final word is that no one can know what is really going to happen in the next three to six months. Obviously, the corporate markets are very dependent on the actions to come.