Our Outlook for the Credit Markets
Credit spreads are near their widest levels since the credit crisis as fundamentals continue to be overshadowed by Europe's efforts to contain the sovereign debt crisis.
Corporate Bonds: Right Back Where We Started
Last quarter we opined that credit spreads would be whipsawed by the ever-changing headlines out of Europe, and we were proven correct in our assessment. Credit spreads tightened throughout most of October, but quickly gave back their gains in November and ended the quarter almost right back where they began.
Credit risk is being priced near the widest levels since July 2009 when the market was recovering from the mortgage crisis. The underlying fundamentals of individual issuers continue to be generally benign. However, over the first quarter we think fundamentals will continue to be overshadowed by Europe's efforts to contain the sovereign debt crisis. Expect volatility.
Corporate bonds rallied in October on reports that the EU was coordinating a new plan to stem the sovereign contagion among the weaker eurozone nations. This "Grand Plan" was a three-prong approach to increase available financing for maturing sovereign debt, require European banks to increase capital levels by mid-2012, and institute a voluntary principal reduction on Greek debt. Unfortunately, the plan began to unravel in November as all three prongs ran into headwinds. As this plan failed to assuage investors' fears, Italian and Spanish bonds began to drop precipitously, forcing EU policymakers back to the table.
At the December summit, the EU (except for the U.K.) announced an agreement among member nations to improve fiscal discipline. This framework would: a) integrate balanced-budget rules into each individual member's constitution with automatic correction mechanisms; b) provide for automatic consequences upon excessive deficits; and c) implement new rules to oversee draft budgets and correct excessive deficits.
Investors' enthusiasm was muted, however. They have been through this same situation too many times before. With each prior announcement the markets initially rose, only to decline a short while later as the plan was found to be lacking. The most recent plan contained few details other than that the members agreed to agree to create and approve the framework by the end of March. Unfortunately, the statement lacked any of the specifics regarding enforcement mechanisms that we wanted. Enforcing fiscal austerity and requiring structural reforms will be the key to the efficacy of this plan over time. However, we view this plan as a positive first step--albeit the first down a very long road--to address the underlying cause of the crisis, as opposed to merely addressing the symptoms.
While we expect there will be many bumps along the way, we think improving fiscal discipline will be a positive for the credit markets in general. We have long been skeptical of the plans the EU has put forth, since the prior attempts to solve the crisis merely addressed the symptoms, as opposed to dealing with the underlying cause of the crisis. The prior plans provided liquidity but did nothing to address the solvency of the profligate nations. This plan differs from the previous plans by addressing the finances and structural issues within individual countries.
Credit Risk Increasing in Several Sectors
Last quarter, the number of downgrades from Morningstar substantially outpaced the number of upgrades. The downgrades largely centered around a few specific sectors that have experienced deteriorating fundamentals: shipping & transportation, building materials, and basic materials. The other downgrades were issuer specific, based on either a decline in credit quality from weakening finances or a conscious decision by management to enhance shareholder value at the expense of bondholders.
Considering that the number of downgrades outpaced the number of upgrades in the third quarter (see chart below), we do view credit risk as modestly increasing, but not to the degree that the market has sold off. While the fixed-income markets are typically very adroit in evaluating inflationary risks and default risk, investors struggle how to appropriately price the political dynamics that could lead to the low probability--but high severity--of a full-blown financial meltdown in the European peripheral nations. It appears to us that a significant amount of the spread-widening encapsulates heightened systemic risk emanating from Europe as opposed to an increased probability of default due to deteriorating individual issuer fundamentals.
We expect that individual issuer credit risk will most likely emanate from companies that look to financial engineering (i.e., spin-offs, acquisitions, and debt-funded share buyback programs) to enhance shareholder value. There may be a few cases of private equity firms attempting to purchase companies in a leveraged buyout, but we think those will be few and far between as banks are more interested in preserving capital as opposed to generating fees from financing leveraged transactions.
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 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 that of the rating agencies.
Inflation Expectations Steady
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. At a current level of 2.4%, the absolute level is in the middle of this 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 use all of its levers (and probably create some new ones) to provide liquidity to the economy. With inflation expectations remaining steady, we don't foresee significant changes in interest rates in the first quarter.
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