Jeremy Glaser: For Morningstar I'm Jeremy Glaser. As equity markets continue their sell off I'm here today with Dave Sekera, a bond strategist for Morningstar, to see how the fixed-income market is holding up. Dave, thanks for joining me.
Dave Sekera: Jeremy, good to see you again.
Glaser: So what do you see in the bond markets today?
Sekera: Bond markets are definitely selling off today in sympathy with equity markets. The thing that I would note is that we're really not seeing the same kind of what seems like panic selling in the corporate bond market as what we're seeing in the equity markets. So yes, things are wider; we are probably 7 to 10 basis points wider in the Morningstar Corporate Bond Index. High-grade names are not trading off nearly as much, so the real high-quality stuff is probably only 3 to 5 basis points off. The lower quality as you would expect, the stuff that is more economically sensitive, has traded off more. The banks and the financials, specifically the lower-quality banks, are really getting hurt the most today.
Glaser: At least on the fixed-income side, it doesn't look like we have a repeat of 2008 on our hands right now.
Sekera: No, it's definitely not the same type of environment that we saw in 2008. So if you remember the beginning of the credit crisis really kind of started in late spring, early summer that's when the credit market really started getting affected by all the subprime and the subprime selling off. The equity market came down a little bit in sympathy at that point in time, but it really wasn't the same kind of panic selling.
Then in the summer things stabilized for a little while, and then the fall is when the market just really fell out for a corporate credit. That's when people really started getting concerned about credit counterparty risk. That's when the banks really started recognizing a lot of the losses in the subprime space, and the market really on the credit side understood exactly the magnitude and the depth of the problem that they had at that point in time. And then it was the equity market that caught up to the downside.
This time around, the equity market has been down very substantially since last week it's down 6% as you and I are talking today. However, we're not seeing that same kind of fear and panic in the credit market. People are looking at it and saying, yes there is definitely some problems and we can get into kind of the confluence of factors that's all coming together today between the S&P downgrade, economic indicators that we have seen over the past week which have been weaker than expected, and the ongoing sovereign credit crisis. Those factors are all coming to a head. However, we're pricing in slow to low growth in the corporate bond market. And we're pricing in maybe some additional default risk over the next couple of years, but it's not that immediate jump to default risk where people are worried about doing a trade or doing business with another entity that could be bankrupt within months.Read Full Transcript
Glaser: Let's go ahead and take a look at the S&P move first. As many people know corporate bonds are often priced as spread to the Treasury. Now we're not quite sure if the Treasury is really at that risk-free rate anymore. Is that having a big impact on bond traders today?
Sekera: It's actually having a very positive impact for the bond traders today. So as the equity markets are just cratering as we speak, we've actually seen a huge move in the flight to quality, the flight to safety, which is still the U.S. Treasury bond even with this downgrade. So the 10-year Treasury has tightened up about 20 basis points. It's getting back to near historic lows. The 30-year bond is rallying, as well. So if anyone really had concerns about the long-term credit quality of the United States being able to repay its debt or be able to refinance its debt as it comes due, we're not seeing that in the bond market. Now on the corporate credit side, while we're seeing the spreads widen out on an all-end yield basis even if we're 7 to 10 basis points wider on the corporate credit spread, your all-end yield is actually still tighter interestingly enough.
Glaser: So it sounds like people have stalled their buying Treasuries, they not that worried about the S&P downgrade. What are some of the things that people are worried about? Is the slowing economy or potential of a slowing economy, something that's weighing on people's minds?
Sekera: I think the S&P downgrade really kind of brought this to a head. So as we mentioned before, we have the ongoing sovereign debt crisis over in Europe. Italy is having a very tough time; its bonds have been falling for quite a while now. Spain has been in the news for quite a while. Portugal and Ireland both had to have their own bailouts. So, we have had that going on where people are concerned about Italy's ability to keep funding itself at rates that make sense for the kind of GDP growth that they have.
If Italy were to require a bailout, considering the difficultly we've had just with Greece which is substantially smaller than Italy, it really becomes a large problem there. If Italy were to have to take haircuts on its bonds in order to survive that could have a very large impact for the Italian banks and start a contagion across Europe where people then would worry about who has exposure to Italy, who has exposure to the Italian banks and so on.
So, we've got that crisis that still hasn't been totally mitigated yet, but interestingly enough the ECB, the European Central Bank, has been intervening in the market over there ,buying the Italian bonds, and buying the Spanish bonds. We saw those gap up about six points overnight, kind of an unprecedented move to the upside in sovereign debt trading.
Now, here in the U.S. we had the first-quarter GDP revision and the second-quarter GDP come out; both of those numbers were substantially lower than what the market had expected. So, I think we have a lot more fears that the economy has been a lot slower in the first half of the year, and people that were looking originally for 3% to 3.5% GDP growth for the full year are now looking at a slow- to low-growth environment.
On top of that, S&P comes out and downgrades the United States to AA+, and we can get into next just kind of what that means in context of a rating. But I think what we're doing is we're looking and seeing that austerity might be coming to the United States. And if austerity is coming to the United States, we're looking at some very large budget cuts. We're looking at cuts in government spending, and maybe those cuts are being brought forward a lot more than what people were expecting.
So, we have this headwind that's coming. So, if I am a portfolio manager or if I'm an analyst, my expectations are for the future, instead of a 3% to 3.5% GDP growth, we're looking for something that's maybe a couple of percentage points. And so therefore now my top line is going to be lower; I might not have the same kind of margin growth. In fact I may have margin pressure, which could have earnings pressure, which is what the equity market I think is really taking a look at.
On the corporate credit side, our fundamentals are still pretty good. Credit metrics are looking good; free cash flow has been good. We don't have near-term jump to default risk. So, now I'm taking to look at it with my credit hat on, and even though I maybe a pessimist at heart, I'm saying things really aren't that bad just yet. But there will be some increased pressure in the corporate credit market, but I'm really more concerned about a company's ability to repay its debt at the end of the day as opposed to necessarily worrying about where its earnings are going on a day-to-day basis.
Glaser: Certainly there sounds like there is lot of pressures both on the bond side and on the equity side. So, what does the downgrade mean, if it didn't mean the kind of panic in the fixed-income market as I know some people were expecting a few weeks ago? What would the impact mean? Is it more long-term in nature?
Sekera: Well, you have to put in context. So, its a AAA going to a AA+; those are extremely high credit ratings. There are about 20 notches on the scale going from AAA all the way down to D which is for a default. So, we've slipped one notch. Now here at Morningstar, we have more than 700 corporate credits that we have an issuer rating on, of those we have three which are AAA and another three that are AA+. So, when you think of that and put that in the context, it's still an extremely high credit rating that S&P has on the United States.
Glaser: Thanks, for update on the fixed-income market, and we look forward to talking to you as this develops in the coming weeks.
Sekera: Anytime, good speaking with you.
Glaser: For Morningstar, I am Jeremy Glaser.