Our Outlook for the Credit Markets
Investment-grade bond spreads compress, but rising interest rates lead to a quarterly loss.
Quarter-End Insights
- U.S. financials have finished their run of outperformance.
- Market implied inflation is moderating.
- Global economic pressures are adversely impacting credit ratings.
Rising interest rates more than offset modest spread tightening within the Morningstar Corporate Bond Index, leading to a negative 0.44% total return in our Corporate Bond Index year to date through March 15.
The average spread of the Morningstar Corporate Bond Index decreased 7 basis points to 134 basis points above Treasuries; whereas, the yield on the 10-year Treasury bond rose 24 basis points to 2.00%. Credit spreads also tightened across Europe as the average spread within the Morningstar Eurobond Corporate Index decreased 5 basis points to 135 basis points over Treasuries as of March 15.
We view the corporate bond market to be fully valued at current spread levels and expect returns in the low- to mid-single-digit range this year. Currently, the yield on the Morningstar Corporate Bond Index is 2.71%. In order to generate a higher return, one would have to assume that either interest rates will fall below their already low levels, or credit spreads will tighten toward the historically tight levels experienced prior to the 2008-09 credit crisis.
While we think the strong technicals supporting the corporate bond market can push credit spreads slightly tighter in the short run, we don't expect credit spread levels to tighten meaningfully from here. In the run-up to the 2008-09 credit crisis, an abundance of structured credit vehicles such as collateralized debt obligations, or CDOs, and structured investment vehicles, or SIVs, were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised. We doubt that these structures will re-emerge anytime soon. With real interest rates at negative real yields for over the next five years, in order to drive interest rates lower investors would have to be willing to lock in an even greater erosion of purchasing power. We don't expect such an outcome.
Over the second quarter of 2013, credit spreads appear poised to modestly tighten further as strong demand supports the corporate bond market. However, over the longer term, we think the preponderance of credit spread tightening is likely to have run its course. The tightest average spread of our Corporate Bond Index since the 2008 credit crisis was 130 basis points above Treasuries in April 2010, just prior to when Greece admitted its public finances were much worse than previously reported, thus beginning the European sovereign debt crisis. The absolute tightest level that credit spreads have reached in our index was 80 basis points above Treasuries in February 2007, the peak of the credit bubble. Over a longer-term perspective, since the beginning of 2000 the average credit spread within our index is 176 basis points above Treasuries, and the median was 160 basis points over Treasuries.
From a technical perspective, the outlook for the corporate bond spreads couldn't look any better. Demand for corporate bonds remains especially strong as investors continue to pour new money into the fixed-income markets. The new issue market reached record levels in 2012, but yet was still unable to keep pace with investor demand. Dealer inventory in the secondary market also remains near its lows.
As the Fed continues to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets to choose from. This is forcing credit spreads tighter as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. Unfortunately, this action will further penalize savers as the Fed artificially holds down long-term Treasury rates, and fixed-income securities that trade on a spread basis clear the market at levels that are tighter than would otherwise occur. As such, the average yield within our Corporate Bond Index continues to reach new all-time lows.
While technical factors have dominated in the current environment, over the long term, fundamental considerations will eventually hold sway. From a fundamental risk perspective, we see a number of domestic and global factors that could adversely affect issuers' credit strength in 2013.
No matter what resolution is reached regarding the sequestration, we expect the result will be a drag on domestic growth. Globally, we are concerned that slowing growth in the Chinese economy, along with deepening recessions in Europe and Japan, could pressure cash flow for those issuers with global operations. With these factors in mind, we recommend that investors concentrate their holdings in those firms that have long-term, sustainable competitive advantages and strong balance sheets that can weather any economic storm. For the near term, we think bonds of issuers with following attributes will outperform:
- High exposure to U.S. markets, where we anticipate modest economic growth will continue
- Limited exposure to the eurozone, especially the peripheral countries where austerity measures hamper economic recovery
- Exposure to the emerging markets, where economic growth continues to be positive, albeit moderating
- Companies that have the wherewithal to expand capital expenditures and infrastructure investments to take advantage of competitors that lack the wherewithal to re-invest in their businesses
U.S. Financials Have Finished Their Run of Outperformance
Since the second quarter of 2012, we have opined that credit spreads for U.S. banks would outperform the broad corporate market. This opinion was based on our forecast that the credit metrics for U.S. banks would continue to improve over the course of the year. With credit spreads for banks trading wider than equivalently rated industrials, we saw potential for a shift in sentiment toward financials.
Our outlook proved correct, as U.S. banks have handily outperformed over the past three quarters. However, on March 1, we changed our opinion as we think unfolding events in Europe will likely lead to credit spreads widening among European bank bonds, which may then lead to widening credit spreads among U.S. banks. As such, we changed to a neutral view.
The recent election results out of Italy failed to produce a clear winner and resulted in a potentially unstable government. Many observers believe the election results question the willingness of the Italian people to adhere to austerity measures required by the ECB and are essentially a referendum on an anti-euro platform. In addition to the political risk, both Italian and Spanish banks are continuing to experience deterioration within their loan portfolios. If their nonperforming loans continue to grow at the current rate, we think it would likely lead the markets to further question the stability of many European banks.
As we approach our publishing deadline for this quarterly outlook, events are quickly unfolding in Cyprus. Currently, there is a plan to impose a "tax" on depositors as part of a financial bailout plan. At this point, it appears that senior bondholders will not face a principal write-down, but that subordinated creditors will be impaired. Initial reactions to this news have been negative, yet muted. The Cypriot government continues to negotiate with the IMF and Troika to finalize and vote on a plan. If depositors are forced to recognize losses, we think that this precedent could re-ignite the capital flight away from banks in peripheral Europe to core EU countries. While the markets appear sanguine regarding Europe's sovereign risks, we have long held a skeptical view that Europe's structural problems have been resolved.
We also are maintaining a wary eye on China. Dan Rohr, who covers the basic materials sector, closely monitors the country's economy. Due to China's over-reliance on infrastructure expansion as its basis for economic growth, the country exerts a considerable impact on raw material prices. Rohr sums up his opinion as such: "We question the sustainability and soundness of the recent reacceleration in China, which has been heavily dependent on infrastructure, heavy industry, and real estate and shows little evidence of a shift toward more sustainable consumption-led growth. Investors face two risks in the near term: Beijing may look to take away the punch bowl as it seeks to rebalance the economy, or the debt accumulation that has accompanied the decade-long investment boom will begin to drag heavily on growth."
Market Implied Inflation Moderating
Market-implied inflation expectations moderated last quarter following the spike driven by FOMC's announcement last fall that it would purchase $45 billion of long-term Treasuries after Operation Twist ended.
Our preferred measure of inflation expectations is the five-year, five-year forward inflation breakeven rate. This rate rose as high as 3% last September after the FOMC's announcement, but has since moderated to 2.57%. For those who are not familiar with the five-year, five-year forward inflation breakeven rate, it is the average annual inflation rate expectation for five years, five years in the future (that is, years six through 10). It is calculated by stripping out the inflation rate embedded in five-year TIPS from the inflationary rate embedded in 10-year TIPS. If inflation does rise to these levels, investors who are purchasing 10-year Treasury bonds today (near 2%) in a flight to safety are locking in negative real yields, which will slowly erode their purchasing power over time. For 2013, Morningstar director of economic analysis Bob Johnson continues to expect inflation will range between 2.0% and 2.5%.
Global Economic Pressures Have an Adverse Impact on Credit Ratings
During the first quarter, ratings downgrades outpaced upgrades mainly due to seven downgrades in the Basic Materials sector. Within the Basic Materials sector, we downgraded five coal companies: Teck Resources (TCK) (rating: BBB-), Cliffs Natural Resources (CLF) (rating: BB+), Alpha Natural Resources (rating: B-), Arch Coal (ACI) (rating: B-), and Consol Energy (CNX) (rating: BB-).
Sharply lower estimates in our long-term outlook on metallurgical coal prices drove the downgrades. Ill-timed acquisitions that saddled companies with a stifling amount of leverage heading into the trough compounded the pricing problem for several issuers.
Within the steel sub-sector, we downgraded two companies-- POSCO (PKX) (rating: BBB-) and Companhia Siderurgica Nacional (SID) (rating: BB)--which are continuing large ongoing capital expansion programs, despite lower earnings, which is coming at the expense of credit quality. The lone upgrade in the sector was Steel Dynamics (STLD) (rating: BB+) which has completed substantial operational improvements and, despite lower earnings, has improved its credit metrics. In addition, the firm is near completion of several projects that we expect to come online soon and enhance the firm's economic moat.
The remaining downgrades were predominately due to issuer-specific events. However, we are also seeing some instances where slowing economic growth has led to weaker-than-expected results and deteriorating credit metrics. For 2013, we expect that individual issuer credit risk for domestic issuers will mostly emanate from companies that look to financial engineering (that is, spin-offs, acquisitions, and debt-funded share buyback programs) to enhance shareholder value. Among European issuers and those issuers with greater global exposure, however, we expect credit risk will generally increase within cyclical sectors experiencing the brunt of the recession.
We expect global economic growth will continue to be sluggish in 2013, limiting opportunities for organic growth. In order to enhance shareholder value, management teams will likely continue to look for non-organic ways to support their equity prices. We saw a resurgence in strategic acquisitions during 2012 and expect that trend to continue. Depending on how these acquisitions are structured, the credit implications may be either neutral to negative based on the amount of debt and equity used to fund the buyouts. Leveraged buyouts in 2012 have been modest, as both domestic and European banks were more interested in preserving capital, as opposed generating fees from financing leveraged transactions. However, as domestic banks have rebuilt the capital on their balance sheets, we expect their willingness to fund LBOs will increase in 2013. Private equity sponsors have significant amounts of dry powder and may look to use any pullbacks in the equity market as an opportunity to purchase quality businesses.
*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.
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