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Credit Insights

Here We Go Again: Latest Central Bank Money Printing to Influence Fixed-Income Markets

It has been less than three months since the Federal Reserve ended its quantitative easing program, and now the European Central Bank has stepped up to take its place and flood the world with newly printed money. The ECB announced its plans to begin purchasing EUR 60 billion ($68 billion) of debt per month this March and continue through September 2016. The total size of this purchase program as currently contemplated is EUR 1.1 trillion ($1.2 trillion) and would increase the size of the ECB's balance sheet by about 50% to more than EUR 3 trillion. However, members of the ECB have already stated that if the ECB is not seeing its intended results, then the asset-purchase program could last even longer. The intent of the QE program is to bolster the economy in the eurozone, revive inflation, and raise asset prices.

The monthly purchases will reportedly consist of EUR 45 billion of sovereign bonds, EUR 10 billion of asset-backed securities and covered bonds, and EUR 5 billion of bonds issued by government institutions and agencies. In total, that equates to EUR 855 billion of sovereign debt, EUR 190 billion of ABS, and EUR 95 billion of agencies. Each individual central bank will buy its own sovereign debt in proportion with its capital in the ECB and as much as 20% of the total amount will be subject to a risk-sharing plan if any of the underlying debt defaults.

The near-term economic effect of the program is likely to be modest. The ECB has long made it known to the markets that it was headed down this path, and the fixed-income markets have already priced in much of the program's impact. Long-term interest rates have been steadily declining across the eurozone and are hitting historical lows. For example, the yield on the German 10-year bund has dropped to 0.36% and the 10-year French OAT is currently 0.54%. The lower-rated peripheral eurozone countries have also benefited, as Spanish and Italian 10-year bonds are trading at 1.38% and 1.53%, respectively. Among other European countries whose debt is denominated in their own currency, 10-year U.K. gilts are yielding 1.48% and Swiss 10-year bonds are trading at a yield of negative 0.26%. Some investors are willing to purchase Swiss bonds at a price that locks in a loss as a long-term bet that the Swiss franc will continue to appreciate versus the euro, whereas other investors are willing to purchase shorter-dated euro-denominated debt at negative yields just to protect against the risk of deflation in the euro. There is reportedly around EUR 1.4 trillion of euro area government bonds that are currently trading at negative yields. Most of these bonds are issued from the core European governments with maturities of up to 5 years. This appears to be unprecedented in any other period.

Considering that interest rates are already at historical lows, it is highly unlikely that even lower interest rates will stoke the flames of new economic growth. However, the low interest rates are likely to help drive asset prices higher. Unfortunately for most Europeans, stocks and bonds are not as widely owned by individuals as in the United States, which will mute the impact of the wealth effect. The other asset class that will benefit from low long-term rates is real estate. This in turn will help to increase the collateral value that the European banks lent against before debt crisis. As the collateral value securing banks' loan books had declined over the past few years, those banks have been especially wary of making new loans or refinancing existing loans. As the value of the real estate appreciates, it will allow the banks to roll over loans that otherwise may not have had enough collateral value to refinance. This should help to bolster the banks' balance sheets, improve recovery values for loans that do end up in default, and in turn increase credit availability in the eurozone.

The greatest near-term impact of the QE program has been the devaluation of euro versus other currencies. Since the announcement, the value of the euro in dollar terms dropped 3.5% in just a few days. In anticipation of the QE program, the value of the euro had already been steadily dropping, falling 7.4% since the beginning of the year and more than 17% over the past 12 months. Currently, the euro is at its lowest exchange rate to the dollar of the past 11 years. From a business point of view, the sliding euro will help improve exports as goods that are denominated in the devalued euros are cheaper in foreign currency terms. From a consumer's point of view, the devalued euro will drive up the cost of any imported products and act as a headwind on consumer spending. While increased credit availability and rising exports should help to revive the European economy, this monetary program would have been more effective if it had been launched in conjunction with fiscal and economic reforms to address the structural economic impediments in the eurozone.

Effect on Corporate Bond Markets
The minuscule interest rates on fixed-income securities in Europe as compared to the U.S. will probably keep interest rates on U.S. Treasury bonds from rising in the near term and may even push U.S. interest rates down further. For example, the yield on the 10-year U.S. Treasury is currently 1.82%, almost 150 basis points higher than the 10-year German bund. U.S. Treasury bonds offer global investors a significant yield pickup over sovereign European debt and the safety of being denominated in U.S. dollars as opposed to risking losing additional purchasing power if the euro continues to slide against other currencies. In addition, the creditworthiness of the U.S. is still multitudes higher than that of BBB rated Italy and Spain, yet the yield on U.S. bonds is higher than both of those countries.

With interest rates on sovereign bonds in developed markets at such low rates, corporate bonds should perform well on a relative basis. As the ECB purchases sovereign debt and ABS, the proceeds will need to be reinvested somewhere, and the path of least resistance will be the corporate bond market. This demand is likely to drive corporate credit spreads tighter. As corporate credit spreads in Europe contract, it will naturally pull credit spreads tighter in the U.S. Investors who can purchase debt in either euros or U.S. dollars will gravitate toward the debt that offers both greater spread and a higher all-in yield, which is currently the U.S. dollar-denominated debt.

As credit spreads tighten, performance of corporate bonds between sectors is likely to be bifurcated in the near term. The sectors that will perform the best will be those that are not exposed to low oil prices or basic material commodity prices (such as iron ore, coal, and copper). Bonds in the energy sector currently offer the highest spreads for their rating, but unless oil prices recover substantially in the next few months, we expect that defaults in the energy space, especially among the smaller service companies, will pick up this fall. Most exploration and production companies have hedged enough of their 2015 production to make it through this year, but as their hedges begin to expire, those E&P companies with higher break-even costs on a per barrel of oil basis will start to default in 2016. These defaults could continue to pressure the entire energy sector and force spreads to widen even further, especially as the value of oil fields will be depressed and recovery values will be slim.

As such, many portfolio managers have positioned themselves to be neutral or slightly underweight the energy sector. The intent is to capture some of the higher credit spread the sector currently offers and maintain enough exposure to keep up with the corporate bond market index if the sector rallies so as to not lag the upside performance. Yet many portfolio managers are not willing to overweight the sector, as oil continues to languish in the mid- to upper $40s and they want to hold some dry powder in reserve to invest in the sector if it takes another leg downward. If oil prices recover in the next few months, we would expect to see spreads in this sector begin to recover relatively quickly as investors reach for the additional yield in an environment of overall credit spread tightening.

Corporate Bond Markets Already Feeling Impact of ECB QE
The average spread of the Morningstar Corporate Bond Index tightened 5 basis points last week to +146 with the tightening occurring after the ECB's announcement Wednesday. The Morningstar Corporate Bond Index is our proxy for the U.S. investment-grade corporate bond market. In Europe, the average spread of the Morningstar Corporate Eurobond Index (our proxy for the European investment grade corporate bond market) tightened 2 basis points to +84. The average rating of the Morningstar Eurobond Corporate Index is about a half notch lower than the Morningstar Corporate Bond Index and the duration is 5 years shorter; however, even after accounting for the difference in credit risk and duration, it appears that there is room for U.S. investment-grade corporate bonds to tighten relative to European investment-grade corporate bonds. In the high-yield market, the average spread of the Bank of America Merrill Lynch High Yield Master II Index tightened 9 basis points to +530.

According to several sources, global investors are already beginning to reallocate funds from the European fixed-income markets to the U.S. markets. This extra demand will help to drive prices on U.S. dollar-denominated fixed-income securities higher.

Syriza's Political Victory Raises Questions
Regarding Greece's Future in Eurozone

The Syriza party in Greece won a significant victory that will quickly reshape Greek politics and raises questions regarding Greece's future in the eurozone. Syriza ran on a platform that included a pledge to write off half of Greece's international debt. The implications of such a debt restructuring is a wild card in the cohesiveness of the European Union. If Greece does push through a restructuring or defaults on its debt, it could shake up bondholders. However, even if the country does default, the implications are different now than they were in 2010. Most of the country's debt is held by official creditors such as euro area governments, the International Monetary Fund, and the ECB. Unlike in 2010, when the market was concerned that European banks would face solvency problems if Greece defaulted, the sovereign and nongovernment organizations will not face insolvency if Greece defaults. As part of a restructuring or default, Greece could redenominate its currency from the euro back into a national currency such as the drachma. While the direct effects of losses from a Greek default and redenomination are manageable, it could set a precedent for other countries that fall into financial distress. If a larger country such as Italy or Spain were to default and/or redenominate its currency, the impact to the global markets would certainly be much more severe.

Chinese GDP Holding Up for Now, but We Expect Faltering Real Estate
Will Pressure Economic Growth Lower

China reported that its gross domestic product in the fourth quarter of 2014 rose 7.3% from a year earlier and grew a total of 7.4% in 2014. However, we suspect that the current growth rate is not necessarily indicative of China's ability to sustainably continue to grow at this rate. A significant amount of the growth in China's economy has been driven by a boom in real estate. However, real estate prices have stagnated or declined and demand has faltered, leading to declining new construction starts and slowing real estate sales. Despite deteriorating fundamentals, though, real estate has continued to add meaningfully to China's GDP growth.

As we noted after the release of second-quarter figures, the apparent disconnect is a consequence of how GDP is calculated. GDP number crunchers are mainly focused on changes in floor space under construction. As long as starts (inflow) exceed completions (outflow), floor space under construction rises and so too will real estate fixed-asset investment. While starts and sales have declined this year, floor space under construction continues to rise.

With faltering starts and sales, floor space under construction growth is likely to weaken in the next several quarters. With it, so will real estate fixed-asset investment and GDP. The situation should change in 2015 with the arrival of the 2010 starts vintage. Starts rose a staggering 42% in 2010. We expect completions to rise accordingly in 2015. This would subtract meaningfully from floor space under construction. In doing so, the stage would be set for a diminished GDP contribution from real estate in 2015, provided starts remain weak. For further detail on how real estate affects China's GDP, please see "Still Not Fully Reflected in China's Headline GDP, Real Estate Woes Will Have a Big Impact in 2015," published by Daniel Rohr, CFA, on Oct. 22, 2014.

In addition to slowing real estate, other coincident and leading indicators in China have also been slowing. For example, HSBC/Markit's Flash Manufacturing Purchasing Managers' Index registered at only 49.8 in January, indicating a slowdown in China's manufacturing sector. This level was just a slight improvement over December's 49.6. A level above 50 indicates expansion whereas a level below 50 indicates contraction. For years, China has been the marginal buyer in the global commodity markets, importing everything from iron ore to coal to copper. As the pace of economic activity has waned in China, the international prices of these materials have plummeted. If our supposition that economic activity in China will continue to cool is accurate, the prices of these commodities may have further to fall. As such, credit spreads on bonds in the basic material sector will probably widen to levels more in line with the current levels in the energy sector. Currently, the average spread in our index for the basic material sector is +211, whereas the average spread in the energy sector is +267.