Our Outlook for the Credit Markets
As the systemic risk from the European sovereign debt crisis subsides, we expect corporate spreads will continue to tighten as credit fundamentals hold steady.
Credit Spreads Should Continue to Tighten
Last October, we highlighted that corporate credit spreads were cheap on a fundamental basis, and the corporate bond market has rallied significantly since then. We expect corporate credit spreads will continue to tighten. Near-term systemic risk emanating from Europe has declined substantially, and we forecast that corporate credit metrics will generally hold steady this year.
The fear of systemic risk within the European financial system was alleviated as Greece successfully pulled off what is essentially an out-of-court bankruptcy restructuring. Although some holders of Greek foreign-law bonds tried to threaten the deal, they were unable to subvert the exchange of existing Greek debt for new bonds with a lower principal amount and longer maturities. Greece implemented collective action clauses it had embedded in its bonds, causing the International Swaps and Derivatives Association to declare that a credit event had occurred, but the auction on March 19 to settle outstanding credit default swaps was uneventful and did not lead to any disruptions in the bond markets.
In addition, at the end of February, the ECB conducted the second round of its long-term refinancing operation (LTRO), in which it lends money to banks for three years at 1%. Under the LTRO, the ECB has lent out a total of EUR 1 trillion ($1.32 trillion). While the long-term effect of the LTRO is unknown, in the near term it has assuaged the imminent liquidity concerns among European banks, which were closed off from the capital markets last fall.
As near-term refinancing risk declined, credit spreads for European banks tightened dramatically, driving much of the outsize returns in Morningstar's Eurozone Bond Index. Subsequent to the LTRO, interest rates among several peripheral European nations have declined substantially as this liquidity has sought higher-yielding assets. For example, since the first LTRO last December, yields on Italy's 10-year bond have dropped below 5% from 7%. While near-term liquidity will not solve long-term solvency problems, it has provided policymakers with more time to address the structural sovereign issues and the related solvency concerns regarding European banks.
With a Greek default off the table and the liquidity from the LTRO supporting European banks, near-term systemic risk originating from Europe has declined substantially. Over the next month or two, as investors focus on issuer-specific fundamental credit risk analysis as opposed to systemic risk, we think corporate credit spreads could tighten another 30 basis points, taking the market back to April 2011 levels. Generally, we think that corporations are healthy, credit metrics are stable, and our outlook for credit risk is positive.
Over the longer term, though, investors will need to evaluate how much a potential slowdown in the growth of emerging markets will impact the developed markets. For example, China recently reduced its target GDP growth rate by 50 basis points to 7.5% and reported a stunning trade deficit in February. Chinese exports, especially to Europe, have declined significantly. In addition, Brazil unexpectedly lowered its short-term interest rates by 75 basis points to 9.75% and reported that fourth-quarter GDP growth decelerated to 1.4%, lower than the 2.7% the country reported for the full year. Political risk could also rear its ugly head again as French elections late in April could alter French-German relations if President Nicolas Sarkozy were to lose the election to the Socialist party's candidate.
Issuer Specific Catalysts Drive Downgrades
Last quarter, the number of downgrades by Morningstar outpaced the number of upgrades, albeit at a slower rate than last quarter. Generally, the downgrades this past quarter were due to specific issuer catalysts as opposed to general economic weakness.
The catalysts that drove the downgrades fell mainly into two camps. First, we downgraded a number of issuers within the health-care sector that had significantly expanded their share repurchase programs to levels in excess of what we thought was prudent for the existing issuer rating. The remaining downgrades were driven by issuer-specific deterioration in which we significantly reduced our projected cash flows. Although we typically would expect that a higher number of downgrades over upgrades would imply increasing credit risk, in this instance we think credit risk is still attractively priced. Across most of our coverage universe, we are forecasting that credit metrics will hold steady over the near to medium term.
* 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.
We expect that individual issuer credit risk will most likely emanate from companies that look to financial engineering (i.e., spin-offs, acquisitions, and debt-funded share-buyback programs) to enhance shareholder value. There may be a few cases of private equity firms attempting to purchase companies in a leveraged buyout, but we think those will be few and far between as banks are more interested in preserving capital as opposed to generating fees from financing leveraged transactions.
Long-Term Interest Rates Poised to Head Higher?
Long-term interest rates rose during the first quarter, with the preponderance of the increase beginning soon after the Fed released its statement following the March FOMC meeting. Within the statement, the Fed highlighted that it is seeing further economic improvement (moving to "moderate" from "modest") and that strains in the global financial markets have eased. In addition, the Fed acknowledged rising inflationary pressures as it noted the recent rise in crude oil and gasoline prices (although it continues to believe that longer-term inflation expectations are stable).
Based on the Fed's language, investor expectations for further quantitative easing or Treasury bond purchase programs diminished significantly. In addition, with the strains in the European sovereign debt and bond markets moderating, the demand for Treasuries as a safe-haven asset diminished as well. The Fed's current version of Operation Twist (selling short-dated Treasuries and buying long-dated Treasuries) will end this summer. Without demand from either the Fed or buyers looking for a safe-haven asset, the remaining buyers of Treasury bonds will be more focused on economic returns as opposed to non-economic factors.
The five-year, five-year-forward break-even inflation rate has bounced between 2% and 2.75% since recovering from the credit crisis and is currently 2.6%. This is in line with Morningstar director of economic analysis Bob Johnson's 2%-2.5% inflation expectation for 2012 and is lower than the current year-over-year growth of CPI (2.9%).
Although we don't make explicit interest rate forecasts, it appears to us that barring a re-emergence of the sovereign debt crisis or some other global calamity that drives a flight to Treasuries, interest rates will likely continue to head higher over the near to medium term. While the range of the real return over inflation has varied over time, we can easily see the 10-year Treasury bond rising toward 3%. If the 10-year Treasury were to increase by 60 basis points, that would more than offset the 30 basis points of credit spread tightening we envision. In such a scenario, even amid a rally in corporate credit spreads, investors could lose value as the price of corporate bonds decreases, although the decline in corporate bonds would be less than Treasury bonds. To avoid such losses, investors may either look to invest in shorter or medium duration bonds, whose price would not be as affected by rising rates, or invest in floating-rate securities.
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