Where the Credit Markets Are Heading

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

I'm joined today by Dave Sekera--he is Morningstar's corporate bond analyst--to take the pulse of that market. Dave, thanks for joining me today.

David Sekera: Anytime, Jeremy. Good to be here.

Glaser: So, let's first take a look at a quick market overview. We're coming to the end of the first quarter. Could you talk a little bit about what happened in the corporate bond market, and anything that was maybe particularly surprising for you?

Sekera: Nothing that was necessarily surprising. Last fall, in some of our publications, we started writing that we thought that corporate credit had gotten to just fundamentally cheap levels last October, last November, and we thought that credit spreads would start to tighten up. And if you remember, that was really the heart of the most recent bout of the sovereign debt crisis in Europe, and we saw spreads here in the U.S. widen out in sympathy with what we saw going on over in Europe.

Credit spreads have definitely tightened in. The Morningstar Corporate Bond Index right now, the spread to Treasuries is about 180 basis points on average over Treasuries. We expect that probably will continue to keep tightening up over the next few months. I'm probably looking for another 40 basis points of tightening until I really start to re-evaluate where we go from there.

Glaser: So looking historically, where are corporate bond spreads now versus where they've been over, say, the last 10 or 15 years?

Sekera: Going back to the late '90s, and our data goes back over the course of past 14 years, the average spread has been about 170, and I said we're at 180 right now.

However, if you look at the median spread and try to strip out some of the effects that we had from the corporate credit crisis here in the U.S. in 2008 and the beginning of 2009 when spreads blew out to just ridiculously wide levels that weren't necessary indicative back then of probability of default risk, but were much more indicative of liquidity risk in the market--and that takes us down to about 150 basis points over Treasuries for the median

Glaser: So as we get closer to that historical average, do you think the fundamentals of the corporate market really support that? Are corporate balance sheet is strong enough to support those spreads?

Sekera: Yes, in fact, talking to our corporate credit analysts and working in conjunction with our equity analysts, we really are basing our view on our expectations and our forward-looking view, and what we're seeing right now is credit metrics, just generally over the course of the next year, we expect them to be pretty steady to slightly improving. Now there are always going to be some instances of issuer-specific events that occur or companies that do things in order to reward shareholders at the expense of bondholders, but generally we're still pretty positive that corporate credit probability of default, call it, should be declining over the near term.

Glaser: So if that default risk isn't very large, another risk that bond investors are always keenly aware of is interest rate risk; rates have been extremely low for a while now. Have you seen any signs of rates potentially starting to tick up or investors starting to get worried about those rising rates?

Sekera: Of course, as you know, at Morningstar, we're really fundamental corporate bond analysts, and we usually try to stay somewhat agnostic as far as underlying interest rates. So we don't really try and give any kind of explicit forecast on where we expect interest rates to go. However, from more of a trading perspective, looking at the 10-year right now, I'd say we're probably more likely to start rising than really stay the same or decrease from here.

There are a couple of different things that I'm looking at. One, I'm looking at inflation; this most recent headline inflation on the CPI number, I believe, was 2.9%. We're taking a look at our own internal expectations for inflation from Robert Johnson, our director of economic research here. He is looking for inflation at a run rate of about 2.5% by the end of this year. So decelerating, but still higher than where we see 10-year Treasury bonds right now.

And then I also look at the five-year, five-year forward, which is essentially future inflation expectations, and generally what that is, is we find out what the market is expecting for inflation within the 10-year TIPS, strip out the inflation expectations in the five-year TIPS, and right now it's between 2.25% and 2.3% inflation expectation for years 6 through 10.

So between all of that, I think that we're more likely to start going up. Investors should demand some sort of real return on their money over time. A lot of what we've seen in the Treasury bond market over the past couple of months, even over the past year to year and a half, it's been the systemic risk that people are trying to evaluate in Europe, and we have the flight to safety, i.e., U.S. Treasuries. So I think there's a lot of demand.

Now, I'm not going to say Europe is fixed, but it certainly been quiet here in the near term, and we don't see any near-term catalysts in order to change that. So I think we have less demand in that flight to quality, and we have the Fed maybe easing off, which on one hand the FOMC statement that came out indicated to the market that they didn't have any near-term quantitative easing programs coming up. Operation Twist should be coming to an end in a few more months, but then again in one of his speeches, earlier last week, Mr. Bernanke was making some indications that maybe he still looking at some sort of accommodative or easing, which he may use to try and help push the job market up higher.

Glaser: So as you mentioned no one knows exactly when rates are going to start to rise, but for investors who might be somewhat concerned about this, do you have any kind of thoughts about ways to position a portfolio that might perform a little bit better, if rates do start to rise?

Sekera: Like I said, we think corporate credit here is still attractive. So I think if you move out of Treasuries and into corporates and pick up that spread which will also lower your duration. So by having a lower duration, even if interest rates do start to rise, you will not get impaired nearly as much as in the value of your bonds. So if you stayed with short- to medium-term corporate credit, I think that the investors will probably be, if not well rewarded, at least fairly rewarded over the near term.

Glaser: Well, Dave, we really appreciate you coming in today.

Sekera: You're welcome. Good speaking with you.

Glaser: For Morningstar, I'm Jeremy Glaser.