Similar to how a corporate management team will provide the market with clues and revise guidance in order to manage expectations when earnings are coming in light, it feels as if the market's expectations for a Greek exit are being managed higher.
Following the inability of the Greek government to form a majority since the recent elections, we have seen reports from each of the major investment banks and many independent think tanks that address the potential outcomes if Greece exits the eurozone and reverts to its own currency. While an exit is unlikely to occur in the next few weeks, the markets are again pricing in an increasing probability that this will occur. Many pundits are speculating it could happen as early as this summer. The next round of Greek elections is scheduled to take place in June, although it is unclear that the government will be able to form a ruling coalition even after this round of elections. It appears that the populace has grown frustrated enough with its situation that it may prefer to take on the risk of going its own way as opposed to sticking it out in the eurozone.
Reports have outlined the steps Greece would need to take to effect this change and have quantified the potential cost to Greece and the wider European Union. In addition, we have begun to hear commentary from the central bankers of several EU countries that addresses the possibility of Greece dropping the euro and the effect on the rest of the EU. Previously, it seemed to be an unwritten rule among central bankers against even publicly speculating on Greece exiting the eurozone, much less opining on the outcome.
While it would cause significant stress in the short term, we think the greater impact is the precedent it would set for other financially beleaguered countries to also potentially exit the eurozone and revert to their own currencies. The European banks may require additional liquidity to function while the capital markets digest the news, but should have enough capital to survive a Greek exit. The greater fear is if other peripheral nations follow Greece's lead, leaving the eurozone and redenominating or defaulting on their debt. If those nations default or redenominate, many of the banks in the peripheral countries would not have enough capital to absorb those losses. As a result, it would wipe out equity-holders and possibly impair bondholders.
Even European banks outside the peripheral countries could be in jeopardy. While those banks may not have as high a percentage of their assets invested in the sovereign bonds of the peripheral nations, they do often have loans extended and counterparty exposure to the banks in the peripheral nations. Losses on these loans and counterparty exposure could overwhelm their capital levels. As those banks fail, the fear is that it could begin a cascading waterfall of defaults, leading to systemic risk across the European financial system.
European Sovereign Debt Weighs on Credit Markets
Since we moved to a neutral opinion on U.S. corporate credit spreads at the beginning of April, credit spreads in the United States had generally held their own as compared with the widening in Europe. However, last week the average credit spread in the Morningstar Corporate Bond Index began to catch up to the weakness in Europe. Our U.S. corporate bond index widened 17 basis points to +210, whereas the average credit spread in the Morningstar Eurozone Bond Index widened 11 basis points to +233.
While the overhang of systemic fear from Europe pressured credit spreads, we think there was additional technical pressure on the credit market stemming from the $2 billion loss announced by JP Morgan (JPM). Since the beginning of the sovereign debt crisis in the spring of 2010, we have recommended (and continue to recommend) that investors favour U.S. corporate bonds over European corporate bonds. In the event that the European sovereign debt crisis spirals out of control, we think U.S. corporate bonds will hold their value better than their European counterparts, just as we saw last fall and winter. If Europe suffers from a deep recession, the U.S. economy will be affected, but to a much lesser degree, as the U.S. economy is not very reliant upon exports to Europe.
In addition, while there are a few issuers in the financial sector that we are comfortable owning, we have been generally underweight the sector, as the financial sector is most susceptible to the systemic risk posed by the European sovereign debt crisis. This underweighting has paid off, as the average spread in Morningstar's US Corporate Financial Index has widened 106 basis points over the course of the past year, as compared with the 48 basis points of widening within Morningstar's US Corporate Industrial Index.
Our recommendation to stick with U.S. corporate bonds has let investors sleep better at night over the course of the past year as the average credit spread in Morningstar's Eurozone Bond Index has been significantly more volatile. Over the past year, the average spread in the eurozone index has widened 96 basis points, ranging 205 basis points between +136 to +341. That compares with our U.S. index, which has widened 71 basis points and has ranged 128 basis points between +139 and +267 over the same period.
Weekly Wrap-Up
The fear of systemic risk emanating from the European sovereign debt markets continues to weigh on the corporate bond markets. The yield on Spain's 10-year bond ended the week off its midweek high, but still elevated at 6.27%. The spread over German bonds rose to a new high of +490 and Spain's 5-year credit default swap spread also rose to new highs, reaching +560. The country's credit curve flattened another 16 basis points to 210 basis points as the yield on the 2-year bond rose 42 basis points to 4.17%. While these levels have all worsened since we first highlighted them at the beginning of April, the absolute yield on both the 2-year and 10-year continues to be lower than where they peaked last November and the 2/10s curve continue to be steeper than at that time.
The pain was not limited to Spain. Italian bonds fell, and the country's CDS also widened out. However, while Italian yields have also been rising steadily, they are still well below the levels they reached last November. In addition, Portuguese and Irish bonds have also been weakening, and their 5-year CDS spreads have been rising as well. Portugal's 5-year CDS has risen to +1,200 and Ireland's 5-year CDS has risen to +708, their highest since the beginning of January but still below their all-time highs.
Adding fuel to the fire, Moody's downgraded a number of Spanish banks, leading to the credit default swaps of a number of Spanish banks to rise. We continue to wait for the outcome of Moody's re-evaluation of its ratings for the U.S. banks and remaining European banks, which could force numerous financial institutions to either reduce lending or raise capital to post additional collateral to their counterparties.
