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Quarter-End Insights

Credit Spreads Widen Further Than Warranted by Fundamentals

Credit spreads widen, but we don't see significantly higher credit risk.

  • Federal Reserve decides to lengthen the duration of its holdings.
  • Corporate credit spread volatility is driven by the ongoing sovereign-debt crisis.   
  • Credit spreads widen, but we don't see significantly higher credit risk.

The Federal Reserve Decides to Lengthen the Duration of Its Holdings
After its September meeting, the Federal Reserve announced its intention to lengthen the duration of its portfolio of Treasury securities by selling short-term bonds and purchasing long-term bonds. In addition, the Fed will reinvest the proceeds from agency securities back into mortgage-backed notes.

Considering this move was telegraphed to the market well beforehand, interest rates declined rapidly over the course of August. The 10-year Treasury declined over 135 basis points to under 2%, and the 30-year Treasury declined 140 basis points to under 3%. Considering the average spread in the Morningstar Corporate Bond Index has widened to +225, corporate bond investors are now generating over half of their total return by accepting credit risk.

Inflation expectations continue to be under control. The five-year, five-year-forward break-even rate has bounced between 2% and 2.75% since recovering from the credit crisis, and the absolute level has been dropping over the past few months. At 2.1%, we believe that the market is pricing in forward inflation near the bottom of the Fed's target range. This allows the Fed plenty of room to steer monetary policy in an effort to boost an economy that continues to muddle along and is dangerously close to stalling out. As long as economic activity is muted, unemployment remains in the upper-single digits, and inflation expectations don't increase, we suspect the Fed will continue to utilize all of its levers (and probably create some new ones) to provide liquidity to the economy.

Corporate Credit Spread Volatility Driven by Ongoing Sovereign Crisis
The bond market is pricing in a near-term default by Greece. At this point it appears to us that the ECB and IMF will continue to support Greece until they have a gameplan in place to deal with the possible ramifications. We suspect that policymakers have been working on a "plan B" to allow Greece to fail while supporting the short-term funding markets, increasing the purchases of Italian and Spanish debt, and recapitalizing insolvent banks.

Fortunately, one thing policymakers have learned in the aftermath of the Lehman Brothers bankruptcy is how to deal with the default of a major financial institution and provide short-term liquidity to banks when traditional liquidity channels freeze. In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor and manage their credit counterparty risk. For example, a credit risk officer at one of the larger regional banks that we recently spoke with mentioned that not only has the bank examined and reduced risk exposure to all of its counterparties, but it has also taken risk management to the second derivative and has been examining the counterparty risk of their counterparties. Margin requirements are higher and strictly enforced, and individual credit limits are much lower. In addition to the financial sector, many large corporations have greatly improved their own internal credit risk management to monitor their customers and counterparties within their own hedging or trading operations.

As we have opined on many occasions, European credit spreads will continue to weaken further and faster than spreads for equivalently rated credits in the U.S. We will continue to hold that view until a comprehensive resolution addresses the long-term structural problems of the overindebted peripheral nations. Until that happens, the solvency of the European banks will continue to be questioned. As investor anxieties rise, liquidity can quickly dry up and lead to short-term funding issues.

Credit Spreads Widen, But We Don't See Significantly Higher Credit Risk
The credit markets took a beating last quarter as reflected in the Morningstar Corporate Bond Index, which has widened 70 basis points since the beginning of August to +225.

The market has not experienced such a rapid and severe sell-off since the beginning of the credit crisis in 2008. After credit spreads widened from their lows in the spring, we thought that credit spreads were fairly valued and did not anticipate such a rout. Considering that our number of downgrades outpaced the number of upgrades in the third quarter, we do view credit risk as modestly increasing, but not to the degree that the market has sold off.

In addition, after talking to each of our credit analysts, we do not see a significant increase in jump-to-default risk across our coverage universe. It appears to us that a significant amount of the spread widening encapsulates heightened systemic risk emanating from Europe as opposed to increased probability of default due to deteriorating individual issuer fundamentals.

Our outlook for corporate credit risk has not changed much since last quarter. The recovery continues to muddle along, but issuers' operating margins and productivity have improved, leading to stronger free cash flow generation. Liquidity in the bond market has allowed firms to term out short-dated debt (at all-time low yields), and balance sheet leverage has generally declined across the board.

Over the course of the fourth quarter, credit spreads will likely continue to be whipsawed by the ever-changing headlines out of Europe. At these heightened levels, from a fundamental viewpoint, we think credit risk is attractive. However, as the European sovereign crisis plays itself out, the market may price in increasing amounts of systemic risk, which could push spreads further. In periods of calm, we expect credit spreads will rally tighter as systemic risk becomes less of a concern and investors concentrate on credit risk fundamentals.

We advise investors to concentrate on those issuers that we deem to have wide or narrow economic moats and significant balance sheet liquidity to ride out any economic storms. In addition, investors can find value in those sectors such as health care and technology where we find numerous issuers in which our credit assessment is higher than the rating agencies.

 Average NRSRO Difference by Sector*
Sector Avg. NRSRO
Basic Materials -0.18
Communication Svs +0.38
Consumer Cyclical +0.28
Consumer Defensive +0.58
Energy +0.1
Financial Svs -0.20
Health Care +1.07
Industrials +0.34
Real Estate -0.23
Technology +1.42
Utilities 0.00
Total Universe +0.34
Source: International Council of Shopping Centers

*The average NRSRO difference shows how many notches away Morningstar's issuer rating is from the average issuer rating assigned by Standard & Poor's and Moody's. For example, if Morningstar rates an issuer BB+ and the agencies rate that issuer BBB-/Baa3, the average NRSRO difference is -1.0. This metric is first calculated for each issuer in Morningstar's coverage universe, and then we calculate the average NRSRO difference by sector.

Click here for our sector-by-sector take and top bond picks.

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