Over the near term, we expect credit spreads to continue to tighten, but longer term, we see possible unintended consequences from the Fed's recent actions.
"Just close your eyes and buy it" is how one credit trader described the fixed-income market this past week. After the Fed put the official stamp on QE2--the second round of "quantitative easing" through which it will buy an additional $600 billion of long-term bonds in a bid to lower long-term rates and stimulate growth--the asset markets were off to the races.
Although the Morningstar Corporate Bond Index tightened just 3 basis points to +152, it felt like the credit market had tightened a lot more. In fact, in the derivative market, investment-grade credit default swap indexes tightened 8 basis points, which took credit spreads back to the levels experienced this spring. As a point of reference, this credit cycle mirrors the tightening cycle earlier this year. It took 74 days for CDS spreads to tighten approximately 30 basis points from +106 in February to +77 in April. In this recent cycle, it took 67 days for CDS to tighten the same 30 basis points from +106 in August. The equity markets have performed similarly, as the S&P 500 increased 15.2% from February to April and 16.8% from August to Friday's close.
As a result of the recent mortgage scandals in the banking sector, credit spreads among financials have lagged industrials in the recent tightening compared with earlier this year. If investors become more comfortable estimating the impact of potential mortgage put-backs to bank credit quality, we would expect the financials sector to catch a bid and lead to additional spread tightening in the Morningstar Corporate Bond Index.
Fixed-income investors coming into the markets with new money were disappointed by the lack of secondary inventory on dealer desks. As one investor put it, "Anything you want to buy, you can't." The new issue market ramped up to fill the void, but even with surging new issuance, investors were still clamoring for more paper.
Over the near term, we expect credit spreads to continue to tighten. With the Fed adding more than $100 billion of liquidity to the market every month until June 2011 and continued demand from institutional and retail investors for fixed income, there doesn't appear to be enough supply to satisfy demand. Exacerbating the lack of supply, Citibank announced in its recently filed 10-Q that it has $40 billion of long-term debt maturing in 2011, of which it expects to reissue only $20 billion. In addition, Citibank does not expect to refinance $58 billion of Temporary Liquidity Guarantee Program debt maturing in 2011 and 2012. If we assume the other large banks have similar maturing and funding requirements, that's a lot of paper coming out of the market.
Over the longer term, we are concerned that one possible unintended consequence of QE2 could be a systemic increase in debt leverage. Companies that pay a high dividend currently have a built-in incentive to issue debt and increase leverage to repurchase equity. For many companies, the aftertax cost of debt is lower than the dividend yield, and the resulting leveraged recapitalization is self-financing and earnings-accretive. These leveraged recapitalizations could cause spreads to widen to account for the additional debt leverage.
Another possible unintended consequence of QE2 is a steepening of the interest rate curve between the 10-year and 30-year Treasury bonds. As seen in the following chart, the 30-year Treasury bond is trading at a historically wide spread to the 10-year. Part of this spread widening is due to dealers pushing up prices in the middle of the curve as they front-run Fed purchases, but we believe this widening is also an indication that investors are beginning to anticipate higher long-term inflation.