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By Jeremy Glaser | 05-25-2011 10:46 AM

U.S. Corporate Bonds Holding Their Own

Morningstar bond strategist Dave Sekera on the recent flood of new issuance, European debt crisis contagion, and the U.S. corporate bond market's health.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I'm joined today by our bond strategist, Dave Sekera. We're going to take a look at some recent developments in the corporate bond market and what it could mean for investors. Dave, thanks for taking the time today.

Dave Sekera: Not a problem. Good to be here Jeremy.

Glaser: In the last few weeks we've seen a lot of new corporate issuance. Can you talk a little bit about what's coming to market and what you think the impact could be?

Sekera: Of course, there's just been a frenzy of new issuance in the past two weeks, both in the investment grade and the high-yield market, and it's just a confluence of a number of different factors coming together all at once.

First, underlying interest rates have been tightening. We see interest rates and the 10 year back to the same kind of levels that we saw at the beginning of this year. Plus, corporate credit spreads have been continuing to tighten as we have expected for a while now, and so between the low interest rates underlying the bonds and the tight corporate credit spreads, just all in, the funding levels for these companies, both investment grade and high yield, are absolutely at just cheap levels right now for these companies. Plus, we've also seen a lot of companies who have been making mergers and acquisitions over the past couple months now finally coming to the market and funding those acquisitions with long-term debt as well.

Glaser: There's a lot of talk about sovereign debt recently, especially in the European Union. Do you think that any of that talk or a potential Greek default or restructuring would have a major impact on corporate credit?

Sekera: Well, I mean, we started talking about this over a year ago now. So really this is not a new issue as far as we're concerned. Our opinion has always been, until there is a long-term plan that's put in place in how they're going to fix these countries' issues, that this was just going to always cause headline volatility, it would dissipate for a while, and then something will come up and a catalyst would bring it back to the surface.

The ECB and the IMF, they're doing their best job, but they still don't really have a plan that the market has bought off on, in how they're going to address these issues. So we're continually hearing about different types of plans, and I think some of this is maybe leaking into the market just to see how the market would react to whether it's a re-profiling, a haircut, whatever they need to do in order to get these countries--Greece, Ireland, Portugal--back in a place where they can be self-sustaining and be able to issue in the markets themselves, continue volatility, and really what we see happening is these spreads even after they've gotten their bailouts, continue to widen the bonds on the dollar price continue to fall.

Now the corporate credit market, which we believe is going to continue to be strong just because of the underlying dynamics and fundamentals of the companies performing well--those credit spreads have been tightening. But what we could see happen is that as we get closer to some sort of resolution that if the banks in Europe do start weakening that that then could cause some slight contagion just across the rest of the credit universe.

So what we saw last time was that the bank spreads or the corporate credit spreads for the European banks we're affected first as people were most concerned about the credit risk there. That then started to bleed into the industrial bonds within Europe, so you would see AA and A banks widen out, investors may take a look at how much you're getting paid for the risk there versus AA and A industrials. Those industrials would then start to follow as well and then you have the investors who can take advantage of playing both sides of the sea, who then would start looking at the kind of returns you could get in Europe, corporate credit spreads versus the U.S., and so then the U.S. started to widen out in sympathy as well.

So really that's the contagion effect that we're most concerned about right now, but here in the U.S. the corporate credit spreads have really held their own. In fact just with the deluge that we've had over the past two weeks of new issuance, I actually had expected the corporate credit markets to weaken a little bit more than they had.

So with the Morningstar Corporate Bond Index, we've really only widened two basis points the last week, and really the traders on the street that I have talked to, what they're really seeing isn't so much that people are selling bonds because they believe there is any increase in the underlying corporate credit risk or any concerns about the fundamentals. They are really selling bonds more to reposition their portfolios. So maybe positions that they had less conviction in, maybe they were selling out some of those bonds, raising cash to be able to invest in the new bond issues. The new bond issues typically have at least a couple basis-point new issue concession, so you can pick up a little extra return in the new issue market versus the secondary market.

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