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Our Outlook for the Credit Markets

Credit spreads are near their widest levels since the credit crisis as fundamentals continue to be overshadowed by Europe's efforts to contain the sovereign debt crisis.

Dave Sekera, CFA, 12/27/2011

--Corporate bonds: right back where we started

--Credit risk is increasing in several sectors

--Inflation expectations steady

Corporate Bonds: Right Back Where We Started
Last quarter we opined that credit spreads would be whipsawed by the ever-changing headlines out of Europe, and we were proven correct in our assessment. Credit spreads tightened throughout most of October, but quickly gave back their gains in November and ended the quarter almost right back where they began.

Credit risk is being priced near the widest levels since July 2009 when the market was recovering from the mortgage crisis. The underlying fundamentals of individual issuers continue to be generally benign. However, over the first quarter we think fundamentals will continue to be overshadowed by Europe's efforts to contain the sovereign debt crisis. Expect volatility.

Corporate bonds rallied in October on reports that the EU was coordinating a new plan to stem the sovereign contagion among the weaker eurozone nations. This "Grand Plan" was a three-prong approach to increase available financing for maturing sovereign debt, require European banks to increase capital levels by mid-2012, and institute a voluntary principal reduction on Greek debt. Unfortunately, the plan began to unravel in November as all three prongs ran into headwinds. As this plan failed to assuage investors' fears, Italian and Spanish bonds began to drop precipitously, forcing EU policymakers back to the table.

At the December summit, the EU (except for the U.K.) announced an agreement among member nations to improve fiscal discipline. This framework would: a) integrate balanced-budget rules into each individual member's constitution with automatic correction mechanisms; b) provide for automatic consequences upon excessive deficits; and c) implement new rules to oversee draft budgets and correct excessive deficits.

Dave Sekera, CFA, is a senior securities analyst with Morningstar.

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