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Quarter-End Insights

Our Outlook for the Credit Markets

2012 was a great year for bonds, but upside for 2013 appears limited.

  • Financials outperform in 2012 and are expected to lead during the first quarter.
  • The Fed is flooding the markets with even more liquidity.
  • The eurozone recession spreads to core countries from the peripheral.
  • Market implied inflation soars.

 

The combination of tightening corporate credit spreads and lower interest rates led to an outstanding return for Morningstar's Corporate Bond Index in 2012. Through Dec. 13, the index has returned 10.2%, thanks to a 100-basis-point compression in credit spreads, a 20-basis-point decrease in the 10-year Treasury bond, and the return from coupon yield.

For 2013, it will be mathematically very difficult to enjoy anywhere near the same return unless one assumes that either credit spreads return to the tightest levels recorded (February 2007) or that interest rates will drop significantly below where they are currently trading, which is already near the lowest rates on record. Assuming corporate credit spreads tighten modestly and that interest rates remain steady, and considering that the yield on the Morningstar Corporate Bond Index is currently 2.40%, investment-grade bonds appear to be poised to return low- to mid-single digits in 2013.

As of Dec. 12, the average credit spread within the Morningstar Corporate Bond Index has tightened to +146. Over the first quarter of 2013, credit spreads appear poised to modestly tighten further as strong technical factors support the corporate bond market. However, over the longer term, we think the preponderance of credit spread tightening is likely to have run its course. The tightest average spread of our corporate bond index since the 2008 credit crisis was +130 in April 2010, just prior to when Greece admitted its public finances were much worse than previously reported, thus beginning the European sovereign debt crisis. The absolute tightest level that credit spreads have reached in our index was +80 in February 2007, the peak of the credit bubble. Over a longer-term perspective, since the beginning of 2000 the average credit spread within our index is +176, and the median was +162.

From a technical perspective, the outlook for corporate bond spreads couldn't look any better. Demand for corporate bonds remains especially strong as investors continue to pour new money into the fixed-income markets. The new issue market reached record levels in 2012, but yet was still unable to keep pace with investor demand. Dealer inventory in the secondary market also remains near its lows. As the Fed continues to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets to choose from. This is forcing credit spreads tighter as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. Unfortunately, this action will further penalize savers as the Fed artificially holds down long-term Treasury rates and fixed-income securities that trade on a spread basis clear the market at levels that are tighter than would otherwise occur. As such, the average yield within our corporate bond index continues to reach new all-time lows.

While technical factors have dominated in the current environment, over the long term, fundamental considerations will eventually hold sway. From a fundamental risk perspective, we see a number of domestic and global factors that could adversely impact issuers' credit strength in 2013.

No matter what resolution is reached regarding the fiscal cliff, we expect the result will be a drag on domestic growth. Globally, we are concerned that slowing growth in the Chinese economy, along with deepening recessions in Europe and Japan, could pressure cash flow for those issuers with global operations. With these factors in mind, we recommend that investors concentrate their holdings in those firms that have long-term, sustainable competitive advantages and strong balance sheets that can weather any economic storm.

For the near term, we think bonds of issuers with following attributes will outperform:

  • High exposure to U.S. markets where we anticipate modest economic growth will continue
  • Limited exposure to the eurozone, especially the peripheral countries where austerity measures hamper economic recovery
  • Exposure to the emerging markets, where economic growth continues to be positive, albeit moderating
  • Companies that have the wherewithal to expand capital expenditures and infrastructure investments to take advantage of competitors that lack the wherewithal to re-invest in their businesses.

 

Financials Outperform in 2012 and Expected to Lead During the First Quarter
Since the beginning of August, the financial sector has been far and away the best performing sector within the Morningstar Corporate Bond Index. Considering the financial sector had been the hardest hit by the sovereign debt crisis, it was no surprise that it outperformed once the fear of systemic contagion from Europe began to subside.

For the first quarter of 2013, Jim Leonard, Morningstar’s corporate bond analyst for the banking sector, expects credit spread tightening in the financial sector to continue to outperform the broader market. Given the higher spread levels within the financial industry compared with similarly rated industrials, along with improving balance sheets and credit metrics, he expects the spread between financials and industrials to close. He does, however, caution that the long-term problems of Europe are far from being solved, and there is always the possibility that the European Union loses control of the situation. Such an event would cause the credit spreads of equivalently rated banks to widen further and faster than industrials.

If a Little is Good, Even More Must be Better: Fed Flooding the Markets With Even More Liquidity
In December, the Fed announced that it would purchase outright $45 billion of long-term Treasuries after Operation Twist ends. In addition, the Fed eliminated the calendar date guidance on how long it anticipated keeping interest rates at zero. Instead, it replaced the calendar date with an unemployment target of 6.5% as long as one- to two-year inflation projections are below 2.5%. Based on the FOMC’s current projections, unemployment would decline to that level sometime in the first half of 2015. If the Fed were to purchase $45 billion of Treasuries and $40 billion of MBS through then, it will increase its holdings by approximately $2.5 trillion, nearly doubling the size of the Fed's current balance sheet.

The intent of the Fed is to support the housing market by reducing rates on mortgages. By keeping mortgage rates low and supporting the housing market, the Fed believes its monetary policy will transmit into the broader economy as home affordability improves and homeowners refinance into lower-rate mortgages, freeing up disposable income. The Fed's premise is that as house prices stabilize and rise, banks will become more willing to extend credit and consumer sentiment will improve as household net worth increases. Considering the zero interest rate policy (ZIRP) was launched in December 2008, that target would entail six and one-half years of ZIRP. With inflation ranging from 1.5% to 2%, real interest rates are negative through the 10-year Treasury, resulting in considerable financial repression for savers.

One aspect of the FOMC's announcement that has been mostly overlooked is that the committee further reduced the midpoint of its expectations for real GDP growth. Since its January 2012 statement, real GDP growth expectations for 2012 have been reduced by 0.7%. For 2013 and 2014, the midpoint of its GDP growth projections has declined by about 0.4%.

Market Implied Inflation Soars
Market implied inflation expectations soared higher subsequent to the FOMC's December announcement that it would continue to purchase $45 billion of long-term Treasuries after Operation Twist ends.

Our preferred measure of inflation expectations is the five-year, five-year forward inflation breakeven rate, which rose to 2.90% after the FOMC's December announcement. Based on our analysis, this is the highest market implied forward inflation rate since the Treasury began issuing Treasury Inflation Protected Securities (TIPS).

For those who are not familiar with the five-year, five-year forward inflation breakeven rate, it is the average annual inflation rate expectation for five years, five years in the future (i.e., years 6 through 10). It is calculated by stripping out the inflationary rate embedded in five-year TIPS from the inflationary rate embedded in 10-year TIPS.

Eurozone Recession Spreads to Core Countries from Peripheral
The ECB recently lowered its economic forecast for 2013 GDP to a 0.3% contraction compared with the 0.5% growth estimate it had forecasted in September. The decrease was largely due to recent weakening in Germany and France, which together account for about half of the eurozone GDP.

Germany, which has long been the pillar of strength, recently lowered its 2012 GDP growth forecast to 0.7% from 1.0%, as GDP is expected to contract 0.3% in the fourth quarter. The country also lowered its 2013 forecast to 0.4% from its June estimate of 1.6% based on its assessment that GDP may also contract in the first quarter of 2013. The ECB held its benchmark refinancing rate steady at 0.75% at its December meeting, but as the recession in the eurozone expands, we would not be surprised to see the ECB cut short-term rates.

While the eurozone economy is poised to contract further in the near term, Spanish and Italian bonds rallied in the fourth quarter. The yield on their respective 10-year bonds dropped 57 and 45 basis points to 5.37% and 4.64%, respectively. The market has priced in lower sovereign default risk and thus lower systemic risk. The ECB created the Outright Monetary Transactions program last fall, which will support nations that officially request financial assistance and accept a macroeconomic adjustment program to be developed by the EU in conjunction with the IMF. In addition, sovereign investors have taken comfort in the continued support of Greece by the ECB, EU, and IMF. As the Troika supports beleaguered Greece, this action indicates that it would also support other countries that become financially troubled and lose capital market access, thus lowering the probability of a near-term default by either Spain or Italy.
 

Global Economic Pressures Adversely Impact Credit Ratings
During the fourth quarter, ratings downgrades outpaced upgrades by a ratio of nearly 2:1. The downgrades were predominately due to issuer specific events such as debt-financed acquisitions, spin-offs, and other actions--including increased share buyback programs and special dividends--where management is willing to enhance shareholder value at the expense of bondholders.

However, we are also seeing some instances where slowing economic growth has led to weaker-than-expected results and deteriorating credit metrics. For 2013, we expect that individual issuer credit risk for domestic issuers will mostly emanate from companies that look to financial engineering (i.e., spin-offs, acquisitions, and debt-funded share-buyback programs) to enhance shareholder value. Among European issuers and those issuers with greater global exposure, however, we expect credit risk will generally increase within cyclical sectors experiencing the brunt of the recession.

We expect global economic growth will continue to be sluggish in 2013, limiting opportunities for organic growth. In order to enhance shareholder value, management teams will likely continue to look for nonorganic ways to support their equity prices. We have seen a significant amount of activity in strategic acquisitions in 2012 and expect that trend to continue. Depending on how these acquisitions will be structured, the credit implications may be either neutral to negative based on the amount of debt and equity used to fund the buyouts. As we have previously opined, leveraged buyouts in 2012 have been modest as both domestic and European banks have been more interested in preserving capital as opposed generating fees from financing leveraged transactions. However, as domestic banks have rebuilt the capital on their balance sheets, we expect their willingness to fund LBOs will increase in 2013. Private equity sponsors have significant amounts of dry powder and may look to use any pullbacks in the equity market as an opportunity to purchase quality businesses.

Click here to read our sector-by-sector outlook for the credit markets >>

*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.

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