Corporate Bond Investors Appear to Be Fading the Rally

Credit spreads tightened 10 basis points over the course of August as the average spread within the Morningstar Corporate Bond Index declined to +173. However, the total return for corporate bonds was largely flat for the month as the yields on Treasury bonds rose, offsetting the gains from credit spread tightening.

While the demand for corporate bonds has driven the credit spread of the Morningstar Corporate Bond Index to its tightest levels over the past year, portfolio managers appear to be fading the rally. For example, both the A and BBB segments of our index have tightened 11 basis points, whereas we would typically expect greater tightening in the lower-quality BBBs in a rally. The movements within our index also suggest that investors have been rotating out of the more cyclical sectors and into traditionally defensive areas. Within the industrial sector, industries such as basic materials and lodging have widened 4-5 basis points, but consumer products and telecom have tightened by 10-15 basis points.

In addition to the movements within the rating categories and sector rotation, a number of traders we've spoken with have also mentioned that they have seen better sellers of 30-year bonds in order to shorten duration. Several mutual funds have been reducing their 30-year exposure and redeploying the proceeds into the 5-7 year range. Even a number of insurance companies, which are the natural buyers of 30-year bonds, have been swapping out of the longest dated paper and into the 15-20-year maturity area.

With credit spreads at the tight end of their longer-term trading range, we think this is a prudent course of action. In the near term, there is the chance that credit spreads could widen out if the markets are disappointed by the actions--or inactions, as the case may be--of the Fed and ECB after their respective meetings. Over the longer term, U.S. economic growth (which is already sluggish) could be affected by the economies of China and other emerging markets, which appear to be slowing, as well as Europe's economy, which continues to contract.

However, any spread widening will likely be short-lived as many portfolio managers will view such backups as buying opportunities. Clients and traders continue to report that they still have abundant amounts of cash that they need to put to work, but are not able to source bonds to purchase. With the dearth of secondary market offerings available, many portfolio managers have begun to take the opportunity to clean up their books and offer out for sale bonds of those issuers for which they want to reduce exposure. While we understand the pressure to put money to work and the desire to pick up additional yield, we recommend that investors continue to be careful.

Bernanke Defends Unconventional Monetary Policy and Is Willing to Use it Again
Bernanke utilized his speech at Jackson Hole to defend the use of unconventional monetary policy, assert his belief that it works, and state that he will continue to employ the Fed's balance sheet through asset purchases if the Fed deems it necessary.

Specifically, he stated the current economic situation is "obviously far from satisfactory" and that "unemployment rate remains more than 2 percentage points above what most FOMC participants see as its longer-run normal value." As such, the market appears to have interpreted his speech to mean that current conditions warrant additional monetary stimulus.

If the Fed implements additional monetary easing though additional asset purchases--without other programs to direct the liquidity to the broader economy--it may help juice asset prices higher, but we think it will have little to no economic impact. The fixed-income markets are functioning normally and awash in cash, and the banks as a whole are sitting on significant reserves. We suspect that if the Fed does implement additional easing, it will be accompanied by other new programs intended to direct the liquidity toward the broader economy rather than the financial markets.

Spanish Yield Curve Steepens to New Heights
Yields on Italian two-year bonds declined to their lowest levels since last March, and Spanish two-year bonds held their recent gains and are near their lowest yields since May. The market appears to be pricing in a high likelihood that the ECB will implement a bond purchase program to reduce interest rates between these two nations. News reports have outlined that any potential purchase program would be conducted in the shorter end of the yield curve, as the ECB believes that would provide the greatest impact for monetary policy to transmit to the broader sovereign economies.

While Spain's two-year bonds tightened 9 basis points last week, its 10-year bonds rose by 41 basis points to 6.86%. This led to a drastic steepening in the 2s/10s curve to a historically steep +320 basis points. Essentially, what the market is communicating is its opinion that the probability of default over the next two years has dropped dramatically, but that the probability of default over the next 10 years is rising.

Headlines on the Horizon: Was August the Calm Before the Storm?
I hope you were able to take advantage of my prior advice to enjoy the break from the headlines during August, because after Labor Day, things are going to heat up quickly.

On Thursday, the ECB will conduct a news conference after its meeting, at which time they will announce any potential rate cuts as well as guidance as to its intentions and plans to purchase Spanish and Italian debt in the secondary market. The caveat here is that the ECB may delay providing any details surrounding its intention to purchase sovereign bonds until after the German Constitutional Court rules next week. Wrapping up the week, the employment situation report will provide greater insight into nonfarm payroll growth and the unemployment rate.

Next week, the German Constitutional Court is expected to rule on Sept. 12 whether it will implement an injunction to prohibit Germany from ratifying the European Stability Mechanism, or ESM. If the constitutional court inhibits ratifying, or rejects, the ESM, it would take the eurozone back to square one in figuring out a way to finance the deficits and maturing debt of the peripheral countries.

On Sept. 13, the Federal Market Open Committee will release its statement following the September meeting and announce any plans to implement further monetary easing.

Assuming the ESM is constitutional under German law, the market will focus on the plan and structure to bail out the Spanish banks. Spanish banks continue to increase their borrowings from the ECB as they are essentially shut out of the public capital markets. It's still unclear as to the structure of the bailout offered to the Spanish banks and whether this debt will have to be guaranteed by the Spanish government, which would increase the country's debt/GDP ratio. In conjunction with uncertainty around the impact of Spanish bank bailout on Spain's credit quality, Moody's may conclude its rating evaluation of Spain. Moody's had placed its Baa3 rating under review for possible downgrade in June, and we are approaching the three-month window in which Moody's usually concludes its rating reviews. And of course, the ongoing negotiations with Greece to allow the next installment of bailout funds should be concluded in September.

In addition to the economic indicators and political events over the next two weeks, both Spain and Italy will need to return to the public bond markets to raise funds to finance their deficits and roll over maturing debt. These auctions will test the depth of the European sovereign bond market to absorb additional peripheral debt. If any of these auctions were to fail, it could be the first domino in a chain that would switch the markets from its current "risk-on" sentiment to a "risk-off" reaction.

Click to see our summary of recent movements among credit risk indicators.

Warren Buffett's Muni Bet: Is the Sky Falling for Municipal Debt Issuers?
Contributed by Candice Lee, Municipal Credit Analyst

Warren Buffett has made headlines lately with various statements and actions that have left investors wondering about this question.

Back in July, when Stockton, Calif., filed for bankruptcy on the heels of other high-profile bankruptcies in San Bernardino, Calif., and Jefferson County, Ala., Buffett warned of the reduced stigma of Chapter 9 municipal bankruptcy filings. Historically, municipal bankruptcy filings had been frowned upon because it sent a negative message to the investor community and presumably would reduce market access for governments that need to issue debt for essential public projects. However, with large entities such as Stockton filing Chapter 9, Buffett asserted that this stigma against bankruptcy was waning, and that more local governments would use it as a tactic for addressing budget deficits and renegotiating labor contracts.

In August, Buffett unwound $8.25 billion worth of municipal credit default swaps that were originally sold to Lehman Brothers Holdings Inc. In effect, these swaps insured against municipal default--if an obligor defaulted on its debt obligation,  Berkshire Hathaway (BRK.A) (BRK.B) would be on the hook for payment. The termination of these swap contracts, presumably at a loss for Berkshire Hathaway, suggests that Buffett perceived increased risk in those municipal bonds, and that the reward from the swaps was no longer worth the risk.

Many commentators have regarded Buffett's move as a signal of an impending wave of local fiscal crises and municipal bankruptcy. Before we all invoke Chicken Little, though, it's worthwhile to look at a few facts about municipal bankruptcy.

First, bankruptcies are extremely rare. Legally, states are not allowed to file for bankruptcy because there is no authorizing legislation from the federal government. At the local level, only 14 states allow municipalities to file for Chapter 9 bankruptcy. Another 13 states will conditionally authorize municipal bankruptcy, but usually only after prior approval by a government official or a state-appointed financial board. There have been only 641 municipal bankruptcies since 1937, amounting to a bankruptcy filing rate of roughly 1% over the last 75 years. In contrast, over 20,000 corporations have filed for Chapter11 bankruptcy in the last 30 years. So far, the number of municipal bankruptcies has not deviated from the trend: There have been nine municipal bankruptcy filings so far in 2012, compared with 13 in all of 2011.

Second, bankruptcies are isolated events. Over half of all Chapter 9 filings have occurred in only five states: Nebraska, California, Texas, Alabama, and Oklahoma. Furthermore, almost all of these filings are by special tax districts or non-essential service providers. In Nebraska, which has by far the largest number of municipal bankruptcy filings over the last 30 years, all 51 Chapter 9 cases were filed by special tax districts owned by property developers, which were understandably sensitive to the housing market and suffered during the downturn. Bankruptcy filings by cities or counties are extremely rare, and though we've seen three cities in California file for Chapter 9 this year, we don't think this is yet fully a trend.

Third, municipal bankruptcy and municipal default are not the same thing. In many municipal bankruptcies, obligors have upheld their debt commitments to bondholders, who often see a full return of principal. Meanwhile, municipal defaults can take on two forms: a "technical default," which occurs when a bond covenant is violated (maintaining an adequate liquidity facility, for example) but no payment has been missed, versus a default in which the obligor is unable to make a bond payment or restructures its debt at a loss to investors. The latter type of default is extremely rare--even rarer than bankruptcy filings. According to the three major ratings agencies, only 0.01%-0.04% of their rated universe has ever experienced default.

Our contention is that we are not, in fact, entering a new normal of municipal bankruptcies, let alone municipal defaults. What the recent bankruptcy filings do reflect, however, is the fiscal strain that is currently being experienced by many local governments. Nationally, stressors such as weak employment growth, stagnant property values, and long-term debt, pension, and post-employment benefit burdens continue to strain municipal entities, some of which have seen recurring budget deficits in recent years.

These stressors are not likely to disappear anytime soon, but they do not paint the whole picture of the municipal analysis: differing economic drivers, debt and fiscal management, state oversight, and legal rules on taxation, expenditure, and debt limits mean that certain geographies and sectors are more resilient to economic headwinds than others. As Buffett retains an $8 billion position insuring municipal bonds, we would assume that he knows this, too.