Containing the Greek Flu

The U.S. bond markets had a relatively quiet month in February. The current relative calm stands in stark contrast to the recent turbulence in fixed-income, driven largely by developments in Europe. For a third consecutive month, credit yield spreads changed little. Speculation over an aid package for Greece kept volatility high in the European markets, and sovereign credit worthiness remains a growing concern. The Morningstar US Core Bond Index, our broadest measure of the U.S. bond markets (includes government-, corporate-, and mortgage-backed bonds), rose 0.3% in February and is up 1.8% for the year.

Containing the Greek Flu
Sovereign credit concerns continue to roil markets as the remedy for Greece and the role of the greater European Union in any bailout remain in question. Measured words from eurozone leaders were successful in stemming a continued sell-off, but credit default swap price action on Greek debt suggests the market still has doubts about a recovery.

The possible contagion to other countries also weighed on the weaker sovereign credits. The Morningstar Eurozone Government Bond Index rose 1.5% in February and is up 1.8% for the year. Under the hood of the index, we see evidence of the magnitude of the flight from risky assets catalyzed by Greece's struggles. Triple-B-rated Greek government bonds have fallen 3.6% for the year, while the triple-A-rated governments in the eurozone (Austria, Finland, France, Germany, and the Netherlands) have risen 2.4% for the year. The single-A and double-A sovereign credits have risen 0.9% and 1.7%, respectively, on the year.

With Greece now having paid the price for fiscal irresponsibility, it appears U.K. Treasuries may now be in the bears' cross hairs. The pound is taking its first hit, and sellers point to the U.K. budget deficit of 12% of GDP, which is similar to that of Greece. The Morningstar UK Treasury Index was the only developed sovereign index to post a decline in February--down 0.2%

There was comparably little drama in the U.S. Treasury markets. The Federal Reserve raised the discount rate--the rate charged to banks for direct loans--for the first time in three years, putting short-term upward pressure on interest rates. Federal Reserve chairman Bernanke signaled that the move was another part of the "normalization" of lending.

The Morningstar US Treasury Index rose 0.4% in February and is up 1.9% for the year. A growing number of pundits are cautioning that the U.S. is not immune to the sovereign credit concerns sweeping the market. Treasuries in the short haul may very well remain a safe harbor for the risk-averse, but as Greece and the U.K. are experiencing first-hand, long-term fundamentals will determine long-term performance.

Uneasy Calm in U.S. Credit Market
For a second consecutive month, yield spreads in the U.S and European credit markets were relatively stable. The yield premium on the Morningstar US Corporate Bond Index stands at 1.6%, exactly what it was at the end of 2009. The index rose 0.3% and is up 1.9% on the year.

The record volume of new issuances that characterized the start of the year came to a screeching halt in February as bond sales were canceled or postponed at the most rapid pace since the onset of the credit crisis. Of primary concern for the borrowers are governments worldwide struggling to reduce their deficits, which is seen as a threat to the recovery. Investors in European banks are also on edge, as exposure to Greece and other weak sovereigns is sufficient to devastate an otherwise improving balance sheet.

The exception to the credit calm is in emerging markets, where yield spread contraction continues apace. The yield spread premium on the Morningstar Emerging Market Corporate High Yield Index contracted 0.3% and now stands at 6.6%. February was the 15th consecutive month of spread contraction from the cycle high of 25.6%. The Corporate Index rose 1.3% in February, and the Emerging Sovereign Index rose 0.3%.

The sovereign credit crisis will not be ending anytime soon, and if Greece turns out to be an epicenter, the tremors will be felt worldwide. The euro is down close to 5% against the dollar, and we are now witnessing the pound following a similar trajectory. The comparisons between the UK's debt burden and that of Greece are coming at a fast and furious pace. The markets know no patriotism, and an out-of-order fiscal house can only be tolerated for so long. To quote Bill Gross, the fund manager of world's largest bond fund, "sovereign yield will narrow in spreads compared to other high-quality alternatives. In other words, yield spreads will become more creditlike."