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Euro Contagion Risks Loom in Corporate Credit Market

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm here today with our bond strategist, Dave Sekera, to get an update on the corporate credit market, and on what investors could expect going forward.

Dave, thanks for joining me today.

Dave Sekera: You are welcome, Jeremy. Good to be here.

Glaser: So let's start talking a little bit about corporate fundamentals, before we get to some of the macro issues, that I know are on a lot of people's minds.

What's really happening in the corporate marketplace? Are balance sheets still remaining strong, even as the economy kind of weakened a little bit this summer?

Sekera: As you mentioned, it has been a crazy time in all of the asset markets, including the corporate bond market. But you know, getting back to just the underlying fundamentals of corporate credit here in the United States, fundamentally, we are still looking pretty good. Third-quarter earnings reports that came out generally were either in line or better than expected. It has been positive for bondholders, looking at probability of default risk across the universe of names that we cover. Things still are pretty even; are still even maybe looking a tad better.

Glaser: So I know in the past, you have talked about self-inflicted credit wounds. Companies either doing a debt-fueled buyback or M&A activity or an LBO or something something like that. Is that a trend that you have seen kind of play out this year, or do you think that companies are still being pretty prudent about their cash management?

Sekera: Of those three, we didn't see the LBOs that we expected this year, we missed that one. We thought there was going to be a lot more private equity activity out there. Debt-fueled LBOs, where we'd see companies get taken out and levered up. It just really did not occur. There were definitely some instances, but we thought it was going to be much greater than it actually was.

However, we have seen a lot more share buybacks, where companies are issuing debt, using that debt in order to buy back the stock, which, of course, is usually negative for bondholders. Having said that--of the names that we follow, the buybacks that they have done, the debt that they have issued, has been within the rating category. So there have really only been a couple of instances where we've downgraded any of the companies that we cover because of that share buyback activity.

Glaser: Now you mentioned third-quarter earnings were reasonably in line or a little bit stronger. But they were really kind of overshadowed in a lot of ways by the crisis in Europe.

What impact do you think that the sovereign debt situation there is having on corporate credits in the U.S. and elsewhere?


Sekera: Well, it has definitely been a rollercoaster. Going back to May of 2010, when you and I first started talking about the sovereign debt crisis, we did write and opined at that point in time that we recommended that investors stick with U.S. corporate bonds as opposed to European corporate bonds, and we still hold that view today.

Now there are instances where we are starting to see some European bonds for the same corporate credit risks that are trading at a higher yield or a wider spread than what we are seeing in the United States. But it's not yet to the point where we are willing to make that call, to go ahead and buy the euro-denominated issues, even if you can swap that back into U.S. dollars. There is just still too much fundamental or really systemic risk of what could happen in Europe right now.

Having said that, in the U.S., PPI/CPI that came out this week, both of those numbers are still showing inflation is well under control here in the United States. Looking at what we call the five-year, five-year forward, which is inflation expectation, stripping out inflation from the TIPS and straight bonds, still within that trading range that we have seen--kind of that 2% to 2.5% for quite a while now.

So, we're really not worried about inflation at this point. We're not worried about the United States as much as we are the contagion effect of what could happen in Europe.

Glaser: So, some of those contagion effects into the U.S. credits, do you think that would come from a weakening of those corporate fundamentals? Would it come from people kind of rushing money into different parts of the bond market that maybe don't expect to get that money? How exactly would that contagion work?

Sekera: Well, it depends on how that contagion first starts. So, what we've been seeing and our bank credit analyst Jim Leonard put out a note earlier this week mentioning that it looks like they're having some liquidity and some funding issues with the Italian banks this week--that the Italian banks have gone to the ECB, asking that ECB to free up some of the collateral guidelines, so that they can take some of their assets, pledge that to the ECB to get additional funding. So it depends if we're looking at a liquidity crisis coming from the banks, or if it's really more of a solvency crisis coming from the nations themselves.

So this week, we have been seeing the ECB trying to defend where the interest rates have been for Italy. Spain's bonds have been weakening pretty dramatically as well. It looks like they have been intervening in that market. Spain issued some new 10-year notes, just inside 7% last night, and 7% on the 10-year has kind of been this litmus test that we have seen in the market, where tighter than 7% as long as the dynamics of the country look like they could be fixed over time, i.e., Italy and Spain, if it's inside 7%, they can probably work it out. But if all of a sudden we start getting wider than 7%, now people are starting to question whether or not those countries would essentially go into a debt spiral, because the interest expense that they have to pay on the debt that they need to issue to fund their deficit, as well as the debt that they need to issue to roll existing debt as it comes due, becomes such that the interest expense becomes more and greater, faster than what they'd ever be able to grow out of with additional GDP.

Glaser: So does it concern you that even after the installation of these new technocratic governments in Greece and in Italy, that those spreads remain so elevated through this week?

Sekera: Yes, and essentially what we've seen is the market keeps going back and keeps testing the ECB to see if the ECB's resolve is really there. So, for example, with that Spanish bond issue that was just auctioned, it was auctioned I think at  6.98%. After it was auctioned, it rallied maybe a good 40 basis points, but then throughout the rest of the day we kept seeing it weaken and weaken further until it got back to that 7%; by the end of the day it looked like it traded maybe just inside that 7%.

Same with the Italian 10-year bonds; we initially saw that blow way through 7% up to 7.4%, it came back in to maybe the six-handle area before it widened back out and then came back in again.

So, the ECB is definitely out there. Well, in my opinion, from what I have heard, it appears that the ECB is in there trying to defend those markets, trying to keep them inside that 7%, trying to make sure that there is enough room that the technocrats, as you want to call it, will have the ability to come in, put in structural reforms, put in some austerity measures, really be able to come in with a couple of different avenues to try and bring their finances under control. But they need enough time to do that, which is part of what the EFSF was originally supposed to do, was to be able to go out and buy bonds in the secondary market.

Part of the latest package was that they were going to try and lever that up so that you could use that in order to bridge and backstop sovereign debt issuance as well as then try and recapitalize the banks if the European banks couldn't recapitalize in the secondary market. We're still waiting to see details on that plan. So, I am still skeptical that that plan really comes through at the end of the day.

Glaser: So, given all of this, for investors who may want to be buying U.S. corporates now, are there certain areas of maturity that look more attractive or certain sectors that look more attractive than others? Where would be a good place to put money to work?

Sekera: On the curve, probably the seven-year duration is probably the most attractive to us at this point. It's where you get the greatest pickup on the yield curve without going too far out on the yield curve. The high-quality names definitely look good. Single-A or better is probably a good spot to be in right now. It gives you additional yield pickup. You can probably pick up 150 basis points to 200 basis points over Treasuries. But it's still a very high-quality name, and even in a downturn, you should have a lot less risk in those single-As than the BBBs. The BBBs at the 250 to 300 range might look attractive, but those bonds are going to be the ones that get hit the hardest if we do see any kind of systemic risk in the system coming out of Europe.

Glaser: Well, Dave, I really appreciate your insight today.

Sekera: You're welcome. Good to be here.

Glaser: For Morningstar, I'm Jeremy Glaser.