'At Least We're Not Greece'
The continual deluge of negative news is wearing down even some of the most upbeat individuals.
We had warned that last week could be a wild ride, and it was. The credit markets were pressured by fears regarding the eurozone's future and a slowdown in China's economic activity, but the markets were hit particularly hard after Friday's payroll report.
For the week, both the Morningstar Corporate Bond Index and Morningstar Eurozone Bond Index widened 7 basis points, to +224 and +247, respectively. The flight-to-safety trade was out in full force as the yield on the 10-year Treasury bond dropped as low as 1.45%, and the 30-year Treasury bond dropped to 2.52%. Considering that the yield on the 10-year Treasury dropped 50 basis points in May to all-time lows, if you haven't refinanced your house in the past few months, it's time to call your mortgage broker.
Those of us on the credit side of the markets typically have a more pessimistic bent. However, the continual deluge of negative news is wearing down even some of the most upbeat individuals. While lamenting the state of the world late Friday evening over a drink with a typically optimistic friend, the most positive retort he could muster was, "Well, at least we're not Greece!" A pretty low bar to set. However, Robert Johnson, Morningstar's director of economic analysis, is not ready to throw in the towel and continues to believe that real GDP growth in the United States will expand 2.0%-2.5% this year. In his weekly economic assessment, he wrote that he thinks the fears that weak economic growth in Europe and China will lead to a recession in the U.S. are overdone. He points to solid same-store retail sales data, personal consumption data, and auto sales, which support his outlook that increasing domestic consumption will offset lower exports.
It was an especially tough week to raise money, but Kraft Foods Group issued $6 billion of bonds to finance its spin-off from Kraft Foods Inc. (ticker: KFT, rating: BBB-) later this year. The notes were priced to sell and proved that even with all of the negative sentiment, there is still a deep bid for corporate bonds. The deal was well oversubscribed, and the bonds tightened significantly in the secondary market. Several European issuers also took advantage of the strength of the U.S. corporate market relative to the European corporate market. British American Tobacco (ticker: BATS, rating: BBB+) and Danone (ticker: BN, rating: BBB+) issued dollar-denominated notes as they found the U.S. credit markets more receptive to new issues than the European markets.
The Rain in Spain Is Not Staying on the Plain
The fear of systemic risk emanating from the European sovereign debt markets continues to weigh on corporate bonds markets. Spain announced that it intends to provide EUR 19 billion of capital to Bankia, its fourth-largest bank. Bankia was created in December 2010 through the combination of seven cajas, which were considered to have the weakest loan profiles and greatest loss exposures of Spain's financial system. This amount of capital is more than 3 times the amount of capital that Spain has already injected into this institution and highlights the probability that Spain will probably incur a substantial amount of debt to bail in its banking system, thus significantly raising its debt/GDP ratio.
It is unclear how Spain will raise this amount of capital: It's more than double the amount of funds remaining in the country's bank restructuring fund, and the yield on the country's bonds is quickly rising. The government originally proposed contributing government bonds into the bank, which in turn could pledge those bonds to the European Central Bank to raise cash, but the ECB rejected that proposal outright. As Spain's debt continues to fall, it's creating a downward spiral in which the markets are questioning if the country has enough bandwidth to finance its deficit, raise the capital needed to capitalize the banks, and refinance the country's maturing debt.
The yield on Spain's 10-year bond ended the week off its high, but at 6.53% it is still well above the market's 6% psychological hurdle rate and is rapidly moving toward 7%, the rate at which the ECB has previously intervened in the markets to either slow or reverse the downward spiral of sovereign bonds to provide European Union policymakers with additional time to develop plans to address systemic risk. The credit spread over German bonds rose to a new high, reaching +539 midweek, and with the yield on the 2-year bonds rising to 5.00% from 4.34%, the 2/10s credit curve flattened to +153. After tightening a few basis points the prior week, Spain's 5-year credit default swap resumed its upward march, hitting a new high of +605.
Once again, we are getting closer to the point where the European governments will need to act before the sovereign debt crisis roils the markets. To break this cycle, policymakers will have to put forth a plan that deals with the losses in the Spanish banking system as well as addressing the structural issues across the EU's labor and regulatory regimes. Until investors can be convinced that the Spanish banks are solvent and have enough capital to absorb the losses buried on their balance sheets, and that the structural imbalances plaguing the peripheral nations will be corrected over time, this cycle will continue.
In the event that the European sovereign debt crisis spirals out of control, we think U.S. corporate bonds will hold their value better than their European counterparts. If Europe suffers from a deep recession, the U.S. economy will be affected, but to a much lesser degree as our economy is not very reliant upon exports to Europe. In addition, while there are a few issuers in the financial sector that we are comfortable owning, we have been generally underweight the sector as it is most susceptible to the systemic risk posed by the European sovereign debt crisis.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.