Counterparty Credit Risk Returns to the Forefront

The corporate bond market continued to feel heavy last week as credit spreads leaked wider in the investment-grade market and were crushed in the high-yield market. The new issue market remained nearly nonexistent across both markets. Over the course of the week, the average spread of the Morningstar Corporate Bond Index widened 5 basis points to +184 bps over Treasuries and the Bank of America Merrill Lynch High Yield Master Index widened 68 basis points to end the week at +683.

At the beginning of the week, credit counterparty risk returned to the forefront of investors' minds as the stock price of Glencore GLEN (rating: NR, no moat) dropped precipitously and prices of the firms' bonds fell off a cliff. Glencore is one of the world's largest commodity traders, active in markets for metals and minerals, energy products, and agricultural goods. The firm's marketing business provides sourcing, logistics, transportation, storage, and financing services to commodity producers and consumers around the globe. Following the 2013 merger with diversified miner Xstrata, the company now ranks as one of the world's largest commodity producers. The main concern was that the credit strength of the company was deteriorating as commodity prices have plummeted this year. If the firm's credit strength declines to the point that it loses its investment-grade status, a substantial portion of the company's clients may halt further trading with Glencore as they would not want to assume the credit counterparty risk inherent in trading with a non-investment-grade counterparty. A downgrade to below investment grade for a trading operation could then lead to a chain of events which if unchecked could lead to a downward spiral. As such, Glencore's bond prices quickly fell; the credit default swap prices began to trade points up front, and the credit curve inverted, both very strong signals of potential jump-to-default risk. Glencore's management team reportedly went into damage-control mode and met with numerous large institutional investors and banks in order to convince the market that the balance sheet was solvent and had plenty of liquidity. By midweek, the panic began to subside as commodity prices rose and the firms' equity and bond prices rebounded, regaining a substantial amount of the losses earlier in the week.

One of the risks in entering a derivatives contract is that the counterparty (the institution that takes the other side of a trade) files for default before the expiration and settlement of a trade. One of the primary fears during the 2008-09 credit crisis was that as asset prices plunged, the solvency of many banks and investment banks was called into question. After Bear Stearns failed, a chain of events began as financial institutions took steps to protect their own balance sheets and rein in risk, which eventually forced Lehman Brothers into bankruptcy. Although it's been seven years, the scars of that experience are still fresh in the minds of many market participants today. While the situation last week was different than in the credit crisis, it was too close for comfort for many institutional investors, who decided to sell first and ask questions later.

3Q Review: Declining Interest Rates Boost Treasury Returns; Risk Aversion Hits Corporate Bond Market The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, rose 1.35% in the third quarter, bringing its return up to 1.43% for the year. As interest rates declined, the long-duration indexes registered the greatest gains. For the third quarter, Morningstar's Short Term Core Bond Index rose 0.38%, the Intermediate Core Bond Index rose 1.46%, and the Long Term Core Bond Index rose 2.35%. The return was predominantly generated by declining interest rates in the U.S. Treasury market as widening credit spreads pressured returns in the corporate bond market. For example, Morningstar's US Government Bond Index rose 1.78% in the third quarter, but the Morningstar Corporate Bond Index rose only 0.49%. Corporate credit spreads widened significantly in the third quarter as plummeting commodity and oil prices weighed on the energy and metals and mining sectors. Overall, the average credit spread of our corporate bond index widened 35 basis points to +188 bps. This is the widest spread the index has registered since mid-2012, when the markets were still in recovery mode after the Greek sovereign debt crisis. The worst-performing sector was metals and mining, which widened out 183 basis points to +412 bps. This was followed by energy, which widened 91 basis points to +285 bps. While consumers will benefit from lower oil prices and cheaper commodities, investors in Treasury Inflation-Protected Securities suffered as inflation and inflation expectations dwindled. As demand for TIPS waned, Morningstar's TIPS Index fell 1.14%, resulting in a 0.95% loss year to date.

The story was similar in Europe, where sovereign bonds registered gains as interest rates declined, but widening credit spreads pressured corporate bonds. The yield on Germany's 10-year bund declined 17 basis points to 0.59%, which helped to push the Morningstar Eurozone Government Bond Index up 2.81% in the third quarter. That return more than offset losses earlier this year and led to a gain of 1.23% year to date. However, as investors looked to reduce exposure in corporate bonds, the average credit spread of the Morningstar Eurobond Corporate Index widened 26 basis points during the third quarter (a total of 48 basis points this year) and currently stands at a spread of +131 bps. Wider credit spreads led to losses in the Morningstar Eurobond Corporate Index, which declined 0.09% and year to date has declined 1.72%.

In our second-quarter outlook published in June, we highlighted that the bubble in the Chinese stock market appeared to be just beginning to pop and that contagion would probably ripple throughout the emerging markets. Since then, the Shanghai Index has continued to drop, falling more than 41% from its peak June 12. In addition, the Chinese government has allowed the yuan to depreciate versus the dollar. Between declining equity prices and weakening foreign exchange rates, capital has been fleeing the emerging markets for the developed markets. As we warned previously, emerging-market bonds are known for being an extremely volatile asset class in a "risk off" scenario. The Morningstar Emerging Market Composite Bond Index fell 2.62% in the third quarter as the Morningstar Emerging Market Sovereign Bond Index decreased 1.19% and the Morningstar Emerging Market Corporate Bond Index declined 3.80%. Year to date, these indexes are registering losses of 0.26%, 0.16%, and 0.54%, respectively.