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. ...