More Sovereign Bailouts to Come?
Without additional structural reform among troubled governmental entities, we expect only a brief respite before the next crisis.
The Morningstar Corporate Credit Index widened 4 basis points to +154 last week. Financials led the index wider with the combination of sovereign credit fears and the Fed's announcement that it is going to conduct another stress test.
On the sovereign credit side, it looks as if we were a little too early last week with our call that Ireland would be bailed out in the near term after the country's credit spreads went ballistic. However, after protesting for the past two weeks that it would not require a bailout, the Irish government has relented and begun to negotiate the form and size of a financing package with the European Central Bank and International Monetary Fund. The Irish government has taken a hard line in its negotiation posture in order to keep as much sovereign control over its finances as possible, especially its ability to keep corporate tax rates lower than the rest those in the eurozone.
We suspect that the final version of a bailout financing plan will center on the Irish banks as opposed to the Irish government. This will allow the current government to save face with its constituents and allow the blame for the financial mess to lie with the bankers. As a result of Ireland's acceding to the pressures to accept a bailout, corporate credit spreads tightened 5 basis points across Europe with the financial sector outperforming industrials. Ireland's credit default swaps tightened 85 basis points to +510, Portugal's tightened 65 basis points to +410, and Spain's tightened 20 basis points to +255. We believe even if a bailout makes Irish sovereign debt safer, it may put pressure on other Irish financial assets.
Closer to home, the municipal bond market has struggled with its own credit issues. California found it increasingly difficult to finance its budgetary deficit and needed to increase the yields paid on its short-term borrowings. While CDS spreads for California have not widened all the way to where they peaked at the end of June, they have widened a quick 30 basis points over the past two weeks to +290. Other states with similar financial issues have also begun to widen. For example, Illinois' CDS has widened 20 basis points over the past two weeks to +292. As these states find it increasingly difficult and more expensive to issue new debt to finance their deficits, participants in the municipal bond market have begun conjecture that the Fed may expand its Treasury bond purchase program to include municipal debt.
Whether it's the ongoing saga in Europe or budgetary pressures in the states, the crises serve to highlight the differences in evaluating the credit risk for governmental entities versus corporate issuers. We continue to contend that the transparency in evaluating the credit risk of corporate issuers is far superior to that of governmental entities. While the world is currently fixated on Ireland, we are concerned that once the bailout financing is completed, the market will move on to target the next weakest sovereign entity. Thus, without additional structural reform among troubled governmental entities, we expect only a brief respite before the next crisis. Who's next? Portugal? California?
New Issue Market
The new issue market wrapped up early last week, and we suspect any remaining deals will have to wait until after Thanksgiving. As an indication that some sanity is returning to the new issue market, we have started to see investors push back on transactions. For example, Burlington Coat Factory pulled its proposed $500 million bond transaction in which a portion of the proceeds were to fund a dividend to the private-equity owners.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.