Counterparty Credit Risk Returns to the Forefront
Third-quarter review: Declining interest rates boost Treasury returns; risk aversion hits corporate bond market.
The corporate bond market continued to feel heavy last week as credit spreads leaked wider in the investment-grade market and were crushed in the high-yield market. The new issue market remained nearly nonexistent across both markets. Over the course of the week, the average spread of the Morningstar Corporate Bond Index widened 5 basis points to +184 bps over Treasuries and the Bank of America Merrill Lynch High Yield Master Index widened 68 basis points to end the week at +683.
At the beginning of the week, credit counterparty risk returned to the forefront of investors' minds as the stock price of Glencore (GLEN) (rating: NR, no moat) dropped precipitously and prices of the firms' bonds fell off a cliff. Glencore is one of the world's largest commodity traders, active in markets for metals and minerals, energy products, and agricultural goods. The firm's marketing business provides sourcing, logistics, transportation, storage, and financing services to commodity producers and consumers around the globe. Following the 2013 merger with diversified miner Xstrata, the company now ranks as one of the world's largest commodity producers. The main concern was that the credit strength of the company was deteriorating as commodity prices have plummeted this year. If the firm's credit strength declines to the point that it loses its investment-grade status, a substantial portion of the company's clients may halt further trading with Glencore as they would not want to assume the credit counterparty risk inherent in trading with a non-investment-grade counterparty. A downgrade to below investment grade for a trading operation could then lead to a chain of events which if unchecked could lead to a downward spiral. As such, Glencore's bond prices quickly fell; the credit default swap prices began to trade points up front, and the credit curve inverted, both very strong signals of potential jump-to-default risk. Glencore's management team reportedly went into damage-control mode and met with numerous large institutional investors and banks in order to convince the market that the balance sheet was solvent and had plenty of liquidity. By midweek, the panic began to subside as commodity prices rose and the firms' equity and bond prices rebounded, regaining a substantial amount of the losses earlier in the week.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.