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Quarter-End Insights

Credit Outlook: Sector Updates and Top Bond Picks

Get our sector-by-sector take on the bond market, plus our five best bond ideas.

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<< Our Outlook for the Credit Markets

For the past several quarters, we've correctly predicted that concerns out of Europe would be the overriding theme for large U.S. banks, and that large U.S. bank credit spreads would remain volatile. Our outlook for next quarter remains the same. European sovereign debt fears continue to strengthen, as do the fears of a potential European banking crisis. In fact, our outlook for European financials has deteriorated, duly reflected in our recent downgrade of six European banks, based mostly in Italy and Spain. This downgrade was driven by our use of a probability-weighted rating methodology, where we estimate an approximate 30% probability of either Spain or Italy defaulting or restructuring in the next five years. This probability was calculated using market-based debt spreads, as well as our own analysis. While we expect that large U.S banks will be able to weather a European storm--thanks to their much improved capital levels--they certainly will be negatively affected. Also looming over the sector is the possibility that a European bank default would result in disastrous consequences for a large U.S. bank due to poor risk controls. While we think this possibility is limited,  J.P. Morgan's (JPM, rating: A) recent multibillion dollar loss on its credit derivatives trades does not inspire confidence that U.S. banks have dramatically improved their risk controls since the 2008 financial crisis.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.