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Quarter-End Insights

Credit Spreads Appear Fairly Valued

U.S. inflation expectations seem to be under control, but sovereign credit quality abroad continues to decline.

  • Inflation expectations held in check 
  • Corporate credit spread volatility driven by ongoing sovereign crisis  
  • Credit spreads fairly valued

Inflation Expectations Held in Check
Commodity prices have risen substantially during the past few quarters, but the increases in both the Consumer Price Index and Personal Consumption Expenditures have been more muted as a result of offsetting declines in other components such as housing. But the key to maintaining price stability isn't just observing and controlling current inflation, but rather observing and controlling the expectation of inflation.

It is widely believed that one of the metrics most heavily relied upon by the Federal Reserve is the five-year, five-year-forward break-even rate. Inflation break-even rates are simply the yield on a Treasury security less the yield on the corresponding Treasury Inflation-Protected Securities. So effectively, if the 10-year Treasury yields 3.00%, and 10-year TIPS yield 0.70%, then the 10-year inflation break-even mark is 2.30%. The five-year, five-year-forward break-even rate is calculated from the 10-year break-even rate by removing the compounded effects of the five-year break-even rate, so that we are just left with the last five years of the 10-year break-even rate.

 

As the preceding chart shows, while there has been some increase in the five-year, five-year-forward break-even rate and the overall rate appears to be at the high end of its historical range, the absolute level is still less than 2.75%. Although this rate is a little over the high end of the believed Fed target inflation rate of 1.50%-2.50%, it's still pretty tame. Some have argued that this rate is being held artificially low through the Fed's second quantitative easing program, since the Fed has been purchasing longer-dated Treasuries and forcing down their yields. While QE2 certainly has had some effect on the break-even rate, it is doubtful that it has had a dramatic impact. If investors truly believed this rate was wrong, they could short Treasuries and buy TIPS, isolating the inflation expectation and profiting from its increase.

With the belief that inflation expectations are still under control, the Fed is free to continue its historically low short-term rates in an effort to boost an economy that continues to muddle along after the economic crisis. As long as economic activity is muted and inflation expectations don't increase, we suspect the Fed will most likely keep short-term rates low, even while actual inflation increases. In effect, the Fed can subsidize an increase in nominal GDP through short-term inflation because the expectation of inflation has not changed.

Corporate Credit Spread Volatility Driven by Ongoing Sovereign Crisis
Although the sovereign debt crisis has been a concern for more than a year now, the markets are becoming increasingly focused on the day-to-day headlines from Greece. The first Greek bailout has been insufficient to tide the country over to the point that it can gain access to the public markets, and now the country is negotiating additional bailout financing.

Even though it appears that the eurozone members and European Central Bank will continue to support Greece in the short run, the eventual default by Greece will be a surprise to no one. The bond market is already pricing in a likely default within the next two to three years. Greece's yield curve is inverted, the five-year credit default swaps are trading more than 2000, and the 10-year bonds are trading at about $0.54 cents. The real test will be whether the ECB has developed plans to mitigate any liquidity issues that might arise from the Greek default.

In our opinion, we think a default by Greece will not cause a widespread financial meltdown. Although many Greek banks hold a significant amount of sovereign Greek debt as a percentage of their capital and would likely fail, it appears that the Greek exposure for most European banks is manageable. For example, reportedly only seven European banks have exposure to Greek debt of more than 10% of their equity. In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor and manage their credit counterparty risk. Thanks to the credit crisis, bankers and bureaucrats have learned how to keep liquidity from drying up by providing a combination of backstops, guarantees, and liquidity. A Greek default with appropriate measures in place to keep the markets functioning would assuage fears that contagion with Portugal and Ireland would bring the financial system to its knees again.

However, a default by Greece without plan by the ECB to provide liquidity to the financial system could cause a liquidity crisis that would reverberate throughout Europe and take its toll on the struggling recovery. In this scenario, sovereign credit spreads would widen and drag both international and domestic corporate credit spreads wider, as well.

In either scenario, our takeaway is that sovereign credit quality in Europe appears to continue its decline. The European peripheral nations have not begun to dig themselves out of their hole yet, and the strongest nations that are funding the bailouts are weakening their credit profiles by taking on additional debt guarantees. Considering the perplexity of the different sovereign bailout funding plans, the off-balance sheet nature of entitlement obligations, and the time lag in reporting economic metrics, fixed-income investors are becoming increasingly wary of the inherent risks in investing in sovereign credit as opposed to corporate credit. This supports our longstanding thesis that corporate credit provides investors superior transparency relative to sovereign credit and should lead to better risk-adjusted returns over time.

Credit Spreads Fairly Valued
Our outlook for corporate credit risk has not changed much since last quarter. The recovery continues to muddle along, but issuers' operating margins and productivity have improved, leading to stronger free cash flow generation. Plentiful liquidity in the bond market has allowed firms to term out short-dated debt, and balance sheet leverage has generally declined across the board. Demand for corporate bonds continues to provide a strong technical backdrop for the market as investors deposited $25.7 billion in investment-grade and high-yield mutual funds through the end of May. We have long opined that the sovereign crisis would generate a pattern of periodic bouts of credit-spread widening, liquidity scares, and subsequent short-term bailout bridge financing until a long-term resolution that addresses the underlying solvency and overindebtedness is put in place. Once the short-term measures are put in place, credit spreads will tighten reflecting the strong underlying fundamentals until the next bout of headlines rears its ugly head.

As credit spreads are whipsawed by the ever-changing headlines out of Europe, we continue to believe that credit quality will remain steady during the next quarter. Credit-spread widening in the corporate sector should be viewed as a buying opportunity, while periods of calm where credit spreads tighten should be viewed as an opportunity to take profits.

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