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Credit Insights

Credit Market Weakness Exacerbated by Gross' Departure From PIMCO

Widening high-yield spreads will start to attract investors.

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It was hard to put a finger on any one factor that caused the weakness in the capital markets last week, but the "risk off" mentality certainly predominated. Some pointed to weakness in German industrial metrics, which resurfaced concerns that Europe is on the precipice of entering another recession, and others pointed to Chinese economic indicators, which indicated that economic growth in China and other emerging-market economies is dwindling. In the corporate bond market, a few traders reported that many mutual fund managers indicated that their cash levels have sunk to very low levels as cash has been used over the past six weeks to absorb the near-record-breaking amount of new issues. In addition to the low levels of cash at the fixed-income funds, one source in the equity market said the volume of initial public offerings in the equity market, including the record-breaking Alibaba (BABA) (not rated, wide moat), had sopped up all of the cash in the equity funds as well and led to selling pressure in the equity markets. On top of the low levels of cash, the credit spreads of new issue bonds have been priced with very little or no concession to outstanding debt and have not performed very well in the secondary market, curbing investor enthusiasm.

While all of these factors played a part in last week's weakness, it was the surprise departure of Bill Gross from PIMCO that exacerbated the sell-off in the bond market Friday. Traders looked to quickly sell down positions, as his departure is thought to potentially cause significant dislocations in the fixed-income markets. If a considerable amount of investors decide to pull their funds from PIMCO, those funds will need to sell bonds to cover redemptions. With low levels of cash and dealers keeping their inventory levels to a bare minimum, even if investors reallocate into fixed-income funds with other mutual fund companies, it will take some time for that amount of cash to be put back to work.

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