Widening investment-grade credit spreads and rising interest rates lead to losses.
This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
At current spreads against U.S. Treasuries, corporate bonds continue to be fairly valued. The average spread within the Morningstar Corporate Bond Index is 167 basis points (Exhibit 1). Although credit spreads may tighten modestly during the third quarter because of strong demand for corporate bonds, we think that over the long term most of the tightening has likely run its course. The tightest spread our corporate-bond index has hit since the 2008 credit crisis was registered in April 2010 at 130 basis points, just before Greece triggered the European sovereign debt crisis. Since the beginning of 2000, the average credit spread within our index has been 176 basis points, and the median has been 160. The tightest level that credit spreads have reached in our index was 80 basis points in February 2007, the peak of the credit bubble.
Return to Fundamentals
We don’t anticipate returning to anywhere near pre-credit-crisis levels. An overabundance of structured credit vehicles such as collateralized debt obligations and structured investment vehicles were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as they were advertised. While there have been some reports that a few investors are beginning to re-evaluate investing in CDOs, we doubt that these structures will re-emerge any time soon in any kind of meaningful size.
As the Fed has been buying mortgage-backed securities and long-term Treasury bonds through its asset-purchase program, investors have had fewer fixed-income assets from which to choose. This has had a positive impact on the demand for corporate bonds as the supply of fixed-income securities contracts and the new Fed-provided liquidity looks for a home. Unfortunately, this action has penalized savers. The Fed has artificially held down long-term Treasury rates, and spread-based fixed-income securities have cleared the market at tighter levels than would otherwise occur. While interest rates have begun to rise from their lows and credit spreads have widened, the all-in yield of the Morningstar Corporate Bond Index is still near its lowest levels (Exhibit 2).
Trying to anticipate the timing of when the Federal Reserve will begin to reduce its asset-purchase program has dominated in the current environment, but over the long term, fundamental considerations will eventually hold sway. From a fundamental risk perspective, we expect corporate credit risk will hold steady over the next quarter, but we recognize there are a number of domestic and global factors that could adversely affect issuers’ credit strength in the second half of 2013.
Moats and Strong Balance Sheets
Robert Johnson, Morningstar’s director of economic analysis, expects real GDP growth in the United States to average between 2% and 2.25% this year. The risk to his view is that consumer spending, which is one of the main drivers of economic growth, may be pressured as incomes stagnate. Globally, we are concerned that slowing growth in the Chinese economy, along with deepening recessions in Europe and Japan, could pressure cash flow and earnings for those issuers with global operations. With these factors in mind, we recommend that fixed-income investors concentrate their holdings in those firms that have economic moats (long-term, sustainable competitive advantages) and strong balance sheets that can weather any economic storm. We think bonds of issuers with the following attributes will outperform: