Credit spreads widen, but we don't see significantly higher credit risk.
The Federal Reserve Decides to Lengthen the Duration of Its Holdings
After its September meeting, the Federal Reserve announced its intention to lengthen the duration of its portfolio of Treasury securities by selling short-term bonds and purchasing long-term bonds. In addition, the Fed will reinvest the proceeds from agency securities back into mortgage-backed notes.
Considering this move was telegraphed to the market well beforehand, interest rates declined rapidly over the course of August. The 10-year Treasury declined over 135 basis points to under 2%, and the 30-year Treasury declined 140 basis points to under 3%. Considering the average spread in the Morningstar Corporate Bond Index has widened to +225, corporate bond investors are now generating over half of their total return by accepting credit risk.
Inflation expectations continue to be under control. The five-year, five-year-forward break-even rate has bounced between 2% and 2.75% since recovering from the credit crisis, and the absolute level has been dropping over the past few months. At 2.1%, we believe that the market is pricing in forward inflation near the bottom of the Fed's target range. This allows the Fed plenty of room to steer monetary policy in an effort to boost an economy that continues to muddle along and is dangerously close to stalling out. As long as economic activity is muted, unemployment remains in the upper-single digits, and inflation expectations don't increase, we suspect the Fed will continue to utilize all of its levers (and probably create some new ones) to provide liquidity to the economy.
Corporate Credit Spread Volatility Driven by Ongoing Sovereign Crisis
The bond market is pricing in a near-term default by Greece. At this point it appears to us that the ECB and IMF will continue to support Greece until they have a gameplan in place to deal with the possible ramifications. We suspect that policymakers have been working on a "plan B" to allow Greece to fail while supporting the short-term funding markets, increasing the purchases of Italian and Spanish debt, and recapitalizing insolvent banks.
Fortunately, one thing policymakers have learned in the aftermath of the Lehman Brothers bankruptcy is how to deal with the default of a major financial institution and provide short-term liquidity to banks when traditional liquidity channels freeze. In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor and manage their credit counterparty risk. For example, a credit risk officer at one of the larger regional banks that we recently spoke with mentioned that not only has the bank examined and reduced risk exposure to all of its counterparties, but it has also taken risk management to the second derivative and has been examining the counterparty risk of their counterparties. Margin requirements are higher and strictly enforced, and individual credit limits are much lower. In addition to the financial sector, many large corporations have greatly improved their own internal credit risk management to monitor their customers and counterparties within their own hedging or trading operations.
As we have opined on many occasions, European credit spreads will continue to weaken further and faster than spreads for equivalently rated credits in the U.S. We will continue to hold that view until a comprehensive resolution addresses the long-term structural problems of the overindebted peripheral nations. Until that happens, the solvency of the European banks will continue to be questioned. As investor anxieties rise, liquidity can quickly dry up and lead to short-term funding issues.
Credit Spreads Widen, But We Don't See Significantly Higher Credit Risk
The credit markets took a beating last quarter as reflected in the Morningstar Corporate Bond Index, which has widened 70 basis points since the beginning of August to +225.