Credit Market Taking a Breather

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Now, that we're more than a week past the recent market turmoil, I thought I'd sit down with Dave Sekera. He's a bond strategist for Morningstar, and we'll take a look at how the credit markets are healing.

Dave, thanks for joining me today.

David Sekera: No problem, Jeremy. Good to be here.

Glaser: So, we talked a little bit last week about dislocations in the credit market in both the corporate credit market and in sovereign debt that happened after the S&P downgrade and worries about Europe. Can you talk to us a little bit about how the markets have performed since the real height of the turmoil?

Sekera: Sure. The credit market really never broke this time around kind of like we saw back in 2008. However, with all the turmoil we saw going on, we saw a lot of people really starting to get scared of what was going on in Europe, a lot of people are starting to be worried about the solvency of some of the European financial institutions. A lot of investors took out their 2008 playbook and were starting to repeat the same sort of trades that they were putting on there. This week, the credit market has really taken a breather. It's taken a step back. People are really looking at the individual positions that they have on, and we're starting to see credit spreads start to normalize now.

So, for example, we saw in Morningstar's Corporate Bond Index that spreads went from kind of the upper 150 range all the way out to as wide as 218. Right now, we're probably sub-200. So, we've gotten a lot of that widening back, but we're still not back to where we were kind of pre-turmoil. By way of background, the average spread during the last 52 weeks has been in the low 150s, and the tightest we saw has been 134.

Glaser: Now, let's take a look at some names that maybe were highlighted last week. Bank of America is one in particular where the equity and the debt really took a beating. How is that performing?

Sekera: So Bank of America really took it on the chin. Taking a look at the bank's five-year credit default swaps, those widened out well wide of 300 basis points, probably in the 320- to 330-type area. We've come back in sub-300s. That had really widened out from, call it, the 170 area beforehand.

Now, the interesting part that we saw in Bank of America was not just the widening of the five-year point but really the entire credit curve had widened out to the point that actually it was inverted such that the credit spreads for one-year and two-year debt were higher than the credit spreads that we saw on the five-year debt.

Now, just as way of background, what that's indicative of is that people were really much more concerned about a potential jump to default or really near-term default risk. There has been talk in the market about whether or not the bank could file the old Countrywide subsidiary that it had bought a couple years ago for bankruptcy and leave the rest of the entity out. Those kind of fears now are subsiding. It kind of goes back to the 2008 playbook when people were really concerned about solvency fears and near-term default risk. But that's now starting to subside as people have really caught their breath and really understood what's going on.

Glaser: Let's take a closer look at Europe. There is a lot of concern about Italy, about Spain, and even France at one point last week. What's happening across the pond?

Sekera: So, the European Central Bank has intervened with the bond markets, and we've seen that Italian bonds, I believe, have moved up about 6 points off their lows. The Spanish bonds have moved up about 7 points off of their lows. So we've seen credit spreads come in about 100 basis points for both the Italian and the Spanish bonds as it spread to German Bunds. So, we've definitely seen a moderation in that market.

As far as credit spreads across Europe, we've talked many months ago why I was much more comfortable owning debt of corporate issuers here in the U.S. than in Europe, and really we saw spreads widen out much further and much faster in Europe. They also are starting to regain some of the losses that they had, but they still haven't gotten anywhere near the kind of returns we've had.

Glaser: So with rates being so low, particularly in the United States, have we seen rash of new issuance where companies trying to tap this market or is there still a lot of more of a conservative bend there?

Sekera: I think I saw probably five or six new deals announced Thursday morning. Usually August is a pretty sleepy month in the corporate bond market. You see a lot of market players that are on vacation this month, so new issuance usually comes down. But taking a look at where interest rates are, I think ever CFO in the world right now is on the phone with their bankers trying to figure out what they can refinance and lock in at these low-term rates.

So, for example, the five-year Treasury is sub-1% as of Thursday morning. The 10-year Treasury is at 2.25%. The 30-year bond is 3.75%; it actually may be even 3.625%. So, even if you're paying a spread of 125-150 basis points during the tenure, you're still locking in money in the mid-3% area for the next 10 years. Some of these CFOs are either trying to refinance that. In some cases, I think they're just raising new debt right now, taking the money while they can, putting it on the balance sheet, and figuring out how to use it later.

Glaser: Dave, thanks for the update. We'll talk to you again soon.

Sekera: Not a problem. Good talking to you Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.