The various types of competition can be grouped as follows:

Pure monopoly: Only one company provides a certain product or service in an area (e.g. post office, local utility companies). It is a result of regulation, patent, license or economies of scale. Earnings are highly predictable since competition is almost nonexistent and the degree of regulation is very high.

Pure oligopoly: A few companies produce the same commodity (e.g. oil, steel). There is enough market share for every competitor. Profit margins will depend on the economic cycle and the cyclicality of industries.

Differentiated oligopoly: A few companies produce partially differentiated products (e.g. cars, computers). The differentiation occurs along lines of quality, features, styling or services. Here it is important to evaluate the different business models of the companies. Profit margins will vary across different industries and companies.

Monopolistic competition: This industry consists of many competitors able to differentiate their products and services (e.g. food, beverage).

Pure competition: Many competitors offer the same product and service (e.g. commodity market). The degree of product differentiation gives an estimate about the margin structure of an industry. Alow product differentiation is accompanied by an intense price competition which results in low profit margins.

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.

The analysis of an industry’s life cycle is useful for making projections about profit margins, earnings growth, trends in sales and profitability. To simplify things it is quite common to reduce the entire life cycle of an industry to 5 stages Such a 5-stage model is described by Reilly and Brown (2003). Abrief description of the different stages will follow next.

Pioneering development: A modest sales growth is accompanied by small or negative profit margins and profits. The firms face high R&D costs. Most recent examples are high-tech companies or internet-based companies with unproven business models. Most of the financing is obtained through venture capital or private equity.

Rapid accelerating growth: Demand for products and services grows and due to only few competitors, profit margins are high. Firms experience substantial backlogs and production capacity is being built up. At this stage successful companies will be able to access the capital markets for further financing.

Mature growth: An increasing number of competitors enter the market. The demand for the industry’s goods and services is satisfied, prices decline and profit margins begin to decline. At this stage financial discipline is important because future earnings might be lower due to competition. Companies with sustainable debt levels will benefit in the long run.

Stabilization and market maturity: The growth rate of the industry declines to the growth rate of the aggregate economy and profit growth will vary by industry due to different competitive structures. Competition will result in lower profit margins. In this stage industry trends will contribute to the development of aggregate credit quality.

Deceleration of growth and decline: Sales growth declines because of changes in demand and new substitutes. An increasing number of companies start to generate losses. The industry experiences a negative credit trend.

The sector selection is one of the most important performance drivers in a corporate bond portfolio. The overweighting and underweighting of different industries is a key element in a corporate bond strategy. The weighting of sectors in a corporate bond portfolio is the result of controlled deviations from the benchmark. They are based on the analysis of the operating environment of specific sectors, a bottom-up analysis of the respective companies and the risk-return profiles of bonds from a specific sector. It is advantageous to set up a corporate bond team by sectors because this structure allows an in-depth coverage of all sectors and the understanding of the competitive environment as well as the market positions and management strategies of single companies out of each sector. An industry consists of a group of firms which offer products that are close substitutes for each other.

Finally, while the subjects of industry analysis and the identification of relative value between sectors are covered in more detail below, it should be noted that the sector allocation has a substantial influence on the risk profile of a corporate bond portfolio. Sectors differ not only with respect to the goods or services they produce, but also with respect to their sensitivity to the economic environment. Therefore, investors usually distinguish between cyclical and noncyclical sectors. In general, cyclical industries are those where the ability to generate revenues and cash flows is closely linked to the business cycle. Usually, this is due to the fact that the companies in those sectors produce goods or services for private consumption or that belong in the category of capital expenditures. Typical examples of cyclical sectors therefore are the automotive and the capital goods sector.