New Issue Volume Overwhelms Demand; Corporate Credit Spreads Widen
GDP and inflation pick up in euro area, which may keep ECB monetary policy on hold.
Corporate credit spreads widened last week as new issue supply overwhelmed demand. The average spread of the Morningstar Corporate Bond Index widened 4 basis points to +130 (its widest level this year), and in the high-yield sector the Bank of America Merrill Lynch High Yield Master II Index widened 7 basis points to +443. Spreads have been under pressure over the past few weeks because of the voluminous supply that has been brought to market. Among the issuers we cover, almost $40 billion of new issues were priced last week, only slightly trailing the $43 billion priced the prior week. Individually, these past two weeks have been third- and fourth-greatest amounts of weekly volume over the past year. The single-largest weekly issuance was in the first week of September as the pent-up deluge after the Labor Day weekend flooded the market. On a combined basis, the past two weeks are greater than any other three-week period since September 2013, when Verizon's megadeal hit the market.
Piling onto this supply, we have heard that there is a full shadow calendar this week as well. With the holiday season closing in, issuers will look to tap the capital markets before the new issue window closes. While investors had anticipated the amount of new issues in the wings, the pace of new issue supply has been even more robust than anticipated. Once the pace of new issues begins to slow and trading in the secondary markets decelerates, we expect credit spreads will grind tighter for the remainder of the year. Even though the Federal Reserve has wound down its asset-purchase program, we expect positive economic momentum will continue through the fourth quarter and forecast GDP growth of 2.0%-2.5% in 2015. While this growth rate is nothing to write home about, it should be enough to keep default rates near the low single digits in the coming year. In addition, both investment-grade and high-yield spread levels have some room to run, as both are still well wide of their tights from earlier this year. The tightest level our investment-grade bond index reached earlier this year was +101 on June 24, and the tightest the high-yield index reached was +335 on June 23.
GDP and Inflation Pick Up in Euro Area,
Which May Keep ECB Monetary Policy on Hold
The European Central Bank held its policy rates steady following its November meeting, but president Mario Draghi intimated that the ECB is prepared to expand its monetary easing policies if economic growth slows and/or inflation slips. The ECB began purchasing covered bank bonds last month and will begin purchasing asset-backed bonds later this month. If the liquidity provided by these programs isn't enough to resurrect inflation and stimulate the economy, the ECB may look to begin purchasing corporate bonds as well as sovereign bonds. The wrinkle in purchasing sovereign bonds is that the ECB is prohibited from directly financing governments. However, as we've seen in other developed markets, where there is a will to print money, central bankers will find a way to develop a program to circumnavigate the regulations. Earlier this month, the ECB reduced its forecasts for GDP growth to 0.8%, 1.1%, and 1.7% for 2014, 2015, and 2016, respectively. Inflation is expected to remain well below the ECB's 2% target at 0.5% in 2014 and 0.8% in 2015.
However, it does not appear that additional easing measures are in store in the near term. Last week, Eurostat released its flash estimate for third-quarter GDP, which revealed that the economic growth rate picked up slightly from the second quarter. Seasonally adjusted GDP rose 0.2% in the euro area during the third quarter compared with a 0.1% growth rate in the second quarter. Germany (the single-largest contributor to GDP in the eurozone) managed to scrape together a 0.1% growth rate for the quarter to keep it from technically entering a recession as GDP constricted by 0.1% last quarter. Similarly, France also kept itself out of recession by expanding 0.3% in the third quarter as compared to a 0.1% decline last quarter. Italy was not so fortunate, though, as its economy declined 0.1% and has not achieved positive growth in more than a year. On the inflation front, while one month does not make a trend, the annual inflation rate increased to 0.4% in October, the first sequential uptick since April.