Corporate bond investors should target industries with a balanced business risk and financial risk profile. In mature industries cash flows become increasingly predictable and capital expenditures of companies tend to stabilize.

In such an industry the task is to select those companies who succeeded in controlling their cost structures and operate at efficient levels.

Those sectors will show a stable credit trend. Structural changes might push a whole industry into a declining stage. Companies out of those industries will experience structural losses, hence their credit metrics will deteriorate. Management will have no options available to stop this trend. In a next step the competitive environment of an industry has to be analyzed.

The 5-Forces diagram by Michael E. Porter summarizes best the interaction of an industry with its economic environment. An understanding of those relationships is essential for the projection of credit trends in a sector. The competitive environment determines profit margins and the pricing power of companies.

Although the consumer sector did surprisingly well, the spreads of cyclical sectors widened massively between the beginning of 2000 and October 2002. Apart from external shocks such as September 11, 2001, there are two economic explanations for this observation. First, the corporate sector increased its leverage dramatically between 1997 and 2001, for the benefit of shareholders and at the cost of bondholders. The high level of leverage made companies vulnerable to economic downturns. Second, the recession that finally occurred in the United States was not typical in the sense that it was not driven by a lack of private demand, but it was rather driven by overinvestment, overcapacities in many industries and as a consequence there was a decline of business investment. The capital goods sector was directly affected by this development and credit spreads widened substantially. The automotive sector, conversely, suffered rather from speculations that the consumer might break away one day. Additionally, the incentive programs weakened profitability in the already fragile automotive sector further and funding gaps in the pension plans materialized following the burst of the equity buble.

On the other hand, noncyclical sectors like banks and utilities performed reasonably well in 2001. The steepening yield curve helped banks to increase their interest margins and thus to offset the costs associated with the declining credit quality in the customer base. The utility sector again justified its safe haven status that is based on the utility companies’ strong ability to generate cash flows.

The breakdown of real GDP in its components highlights the importance of private consumption and investment for the state of the economy. In Q4 2003, personal consumption and investment accounted for 87 percent of US real GDP, that is, these components are major drivers of the economic cycle. Although the National Bureau of Economic Research (NBER) that is responsible for dating recessions employs a variety of indicators to determine the peak and trough of an economic cycle, recessions are usually characterized by declining private demand. Tthis was not true for the 2001 recession. The consumer held up very well, taking on even more debt and thus stretching his balance sheet to the limit.

Tax rebates and incentives like the zero percent financing in the automotive sector supported the high level of consumption additionally, so that the indebtedness of private households reached record highs while the savings rate plunged to extremely low levels by historical standards. This combination explains not only the limited downturn of retail sales during the 2001 recession, but also the sluggish recovery compared to former recessions.