Corporate credit spreads tightened slightly during March, but the market quickly gave up its gains in the first half of April. Part of the reason for this weakness was a response to the accelerating pace at which Spanish and Italian government bonds were falling. Spanish and Italian bond prices peaked in early March and gradually retreated over the course of the month.
We were not concerned about the gradual decline after the strong rally following the European Central Bank's last long-term refinancing operation; however, we are becoming increasingly concerned about the recent accelerating rate at which the countries' bonds are falling. In October, we highlighted that we thought credit spreads were cheap on a fundamental basis, and the Morningstar Corporate Bond Index has tightened 75 basis points since then. However, we believe a more neutral stance is warranted under the current conditions. If the situation in Europe deteriorates, the contagion from heightened sovereign credit risk will affect the corporate credit markets, and spreads will widen across the board.
Early last week, Spain held a bond auction that was poorly received by the bond markets; this caused a swift sell-off of Spanish bonds and also dragged Italian bonds lower. If either country's debt continues to slide from here, it may reignite the European sovereign debt crisis and bring all the problems surrounding these two countries' finances, as well as the solvency of their banks, to the forefront.
After bottoming out at the beginning of March, Spanish and Italian 10-year bond yields have risen substantially over the past two weeks. The Spanish 10-year peaked at 6.07% on April 16 after temporarily breeching the psychologically important 6% barrier. The yield dropped back below 6% to 5.89% on April 17 after a successful Spanish bill auction, but it is still dangerously close to trading above the level that the market deems to be unsustainable over the long term. This Thursday, Spain is auctioning off 2-year and 10-year bonds. While we expect that the auction should be supported by Spanish banks though their funding with the ECB, if this auction were to go poorly, it could be the impetus for the next wave of sovereign debt crisis.
As we saw in the past, once the yield breaches 6% and trades above that level for a few days in a row, it typically will continue on an upward path until some form of government intervention halts the falling bond prices. However, government intervention becomes a double-edge sword. What the market learned through the Greek default is that all bondholders will not be treated the same in a restructuring, as the ECB refused to take losses on the Greek bonds it purchased in the secondary market. While the ECB's secondary market purchases may push yields down in the short term, it effectively subordinates the remaining outstanding bonds held in public hands and will further reduce recovery rates in a restructuring. So even though the ECB may support the bonds in the short term, it puts additional pressure on the bonds as investors will require a higher rate of return to compensate for lower implied loss given default.
While we are worried that the sovereign debt crisis may re-emerge, one positive aspect that has helped to allay our fears is that Spain's credit curve has not yet begun to flatten. The credit curve has been shifting upward, but the rising yield of the 2-year bond has not outpaced the increase in the 10-year bond. Yield curves flatten when the credit markets price in an increasing probability of a near-term default, as investors require higher short-term yields to compensate for jump-to-default risk. In Spain's case, while the market is pricing in higher long-term default risk, it is not yet pricing in substantially higher near-term default risk. However, while the yield on Italy's 10-year bond is lower than that of Spain's, Italy's 2/10s curve has flattened by about 100 basis points to the low 200s over the past month, indicating the market is pricing in greater near-term risk in Italy than in Spain. Then again, at the current level even Italy's 2/10s curve is not pricing in a near-term default as compared with last November, when the country's credit curve inverted.
Contrary to the rising sovereign risk, our corporate credit analysts are generally continuing to forecast steady to slightly improving fundamental metrics across our coverage universe. Therefore, we continue to think corporate credit risk is attractively priced. However, we think a neutral stance is currently warranted, as we have seen how quickly the European sovereign debt crisis can spiral out of control. As such, we recommend keeping a close eye on Spain's and Italy's bonds. If the credit curve for either begins to flatten substantially, or if their 10-year bonds trade substantially over 6% for a time, we would change that view to an underweight as the probability of another flare-up of a sovereign debt crisis and contagion to the corporate bond market would push all credit spreads wider.
Adding to the risks from the decline in peripheral debt, France is holding its presidential election April 22. It appears that neither Nicolas Sarkozy nor Francois Hollande will obtain more than 50% of the initial vote, thus requiring the country to have a second runoff vote May 6. If Hollande wins the election, it could heighten political risk as he has been very critical of the European Union's response to the sovereign debt crisis. He has also made numerous statements questioning the role of the ECB and voicing his desire to renegotiate France's financial support for the sovereign rescue funds.
Adding to the negative sentiment in the markets, China released its first-quarter GDP growth rate, which slowed to 8.1% from 8.9% the prior quarter because of a slowdown in exports and real estate investment. This was lower than expectations, which averaged in the mid-8% area. Chinese officials have previously stated that they expect GDP growth for 2012 to average 7.5% for the full year. If they are correct, then GDP will have to slow substantially over the next few quarters to bring the full-year average down. This highlights the need for the Chinese economy to increase domestic and consumer consumption from being mostly driven from exports and infrastructure investments; however, a shift of this magnitude will take years to achieve as opposed to a few quarters.
