Sovereign Bond Prices Continue to Climb Around the World
Looking at the impact of Europe's quantitative easing program on corporate bond markets.
Prices of investment-grade corporate bonds rose last week as plunging Treasury yields pulled interest rates lower. However, the credit spread on investment-grade corporate bonds widened 2 basis points as the average spread in the Morningstar Corporate Bond Index widened to +148. With the report that real GDP growth slowed to 2.6% in the fourth quarter, the S&P 500 falling almost 2.8%, and volatility rising over the course of the week, buyers of investment-grade corporate bonds were unwilling to chase bond prices higher, thus pushing the credit spreads slightly wider. The Treasury yield curve declined almost 14 basis points across the long end of the curve as the 5-year ended the week at 1.19%, the 10-year at 1.68%, and the 30-year at 2.25%. These yields are near their lowest since April 2013, before former Fed Chairman Ben Bernanke began to intimate to the market that the Fed was nearing the time it would begin to taper the last round of quantitative easing.
While some investors flocked to the safety of Treasury bonds, other investors were enticed by the higher yield offered on below-investment-grade bonds. The average spread of the Bank of America Merrill Lynch High Yield Master Index tightened 4 basis points to +526. Weekly fund flows into high-yield mutual funds and exchange-traded funds of $2.7 billion were the second highest over the past year.
Yields on sovereign debt across Europe have steadily fallen since the beginning of 2014 as the European markets have increasingly priced in an ever-higher probability that the European Central Bank would begin its own quantitative easing program as economic growth stagnated. With the formal announcement that the ECB would begin its QE program in March, the "Japanification" of interest rates in Europe appears to be complete. The yield on the German 10-year bund has dropped to 0.30%, rivaling the 0.28% yield on Japanese 10-year bonds. The 10-year French OAT is currently 0.54%, and even the lower-rated peripheral eurozone countries such as Italy and Spain have declined to heretofore unimaginable levels of 1.59% and 1.42%, respectively. Among other European countries whose debt is denominated in their own currency, 10-year U.K. gilts are yielding 1.33% and Swiss 10-year bonds are trading at a yield of negative 0.04%. 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.
Bond Recommendation Updates After Fourth-Quarter Earnings Reports
As we move toward the end of earnings season, we have changed several of our investment recommendations. For example, we lowered Mattel's (MAT) (rating: A-, narrow moat) bonds to market weight from overweight as leverage climbed above 2 times, which could prompt a credit downgrade if forthcoming turnaround plans do not bear fruit. In addition, the future leadership of the firm remains uncertain after the announcement of the CEO's departure. We also lowered our recommendation on Quest Diagnostics (DGX) (rating: BBB+, narrow moat), as results indicated that deleveraging has stalled with gross debt/EBITDA staying just under 3 times. While we believe Quest will continue to deleverage toward its normalized leverage target in the low 2s, increasing returns to shareholders have slowed that progress. As such, we lowered our recommendation to market weight and view competitor LabCorp (LH) (rating: BBB+, narrow) as a better buy. Lastly, we reduced our recommendation on Anthem's (ANTM) (rating: BBB+, narrow moat) bonds to market weight from overweight. While the former WellPoint reported solid fourth-quarter results, it is increasing its already liberal returns to shareholders. As such, Anthem's financial position will probably remain stable rather than improve significantly in the near future. With the firm still operating with inflated leverage after the Amerigroup acquisition, its credit profile remains on the weak end of its rating category.
On a positive note, Celgene (CELG) (rating: A, narrow moat) reported fourth-quarter results that highlight its strong cash flow generation on key product growth. In our view, Celgene's bonds remain attractively valued, which keeps them on our Best Ideas list. We raised our recommendation on St. Jude Medical (STJ) (rating: AA-, wide moat) to overweight from market weight after it reported solid operating results. We maintained our overweight recommendation on EMC (EMC) (rating: A+, narrow moat) following the release of its fourth-quarter earnings results. While we think event risk around EMC is likely to remain elevated, we believe core EMC can maintain a solid investment-grade rating in the event of a significant corporate restructuring.
Impact of European Quantitative Easing Program on Corporate Bond Markets
The minuscule interest rates on fixed-income securities in Europe as compared with the United States 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 1.68%, which is almost 140 basis points of yield pickup over sovereign European debt as well as offering the safety of being denominated in U.S. dollars as opposed to taking the risk of 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' bonds.
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 asset-backed securities, 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, this will naturally pull credit spreads tighter in the U.S. Those investors that can purchase debt in either euros or U.S. dollars will gravitate toward the debt that offers both a greater spread and a higher all-in yield, which is currently the U.S. dollar-denominated debt. According to several sources, global investors are already beginning to reallocate funds from the European fixed-income markets into the U.S. markets. This extra demand will help to drive prices on U.S. dollar-denominated fixed-income securities higher.
Real GDP Growth Slows to 2.6%, Returning Growth to Normalized Trend
Real GDP rose 2.6% in the fourth quarter of 2014, a significant slowdown from the 4.6% and 5.0% growth rates in the prior two quarters. However, according to Robert Johnson, Morningstar's director of economic research, this deceleration is not anything to be worried about and brings economic growth back in line with his long-term forecasts. Quarterly GDP this year has been affected by several events that caused distortions in quarterly growth reports. For example, the poor weather in the first quarter of 2014 constrained growth during the quarter, but that growth quickly rebounded in the second quarter, leading to stronger-than-expected economic activity. In the third quarter, unusual seasonal factors for federal government spending were a big increase, which then came back and impeded reported growth in the fourth-quarter report. For 2015, Johnson continues to project that real GDP in the U.S. will average between 2.0% and 2.5%. For a more detailed analysis of fourth-quarter GDP, please see his weekly column, "GDP: Back to Trend, Not Down the Drain."
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.