Now that earnings season is essentially over and European politicians are on hopliday (and thus out of the headlines), volatility has dropped substantially. As volatility bounces along its lowest levels for the year, the flight to safety has receded, allowing markets to march higher and prod investors to reach for additional yield.
The average spread in the Morningstar Corporate Bond Index tightened 2 basis points to +174 last week, and the average spread on the Morningstar Eurobond Corporate Index tightened 9 basis points to +181. Both of these indexes have tightened to the lowest spread levels over the past year. The average spread in the eurobond index continues to be wider than the US corporate index but may continue to tighten faster than the US index during this cycle of "risk on" attitude. This could allow for some outperformance by investors with the ability to switch between dollar- and euro-denominated assets.
As the flight to safety has abated, the demand for Treasury bonds has declined, and yields have surged higher. The 10-year Treasury bond rose 15 basis points last week to 1.80% and has risen 30 basis points since the beginning of August. The 30-year Treasury bond rose 18 basis points to 2.92% and has risen 34 basis points since the beginning of August. Both of these levels represent each bond's highest yield since the middle of May. The increase in Treasury yields has more than offset the tightening credit spreads this month as the average yield of the Morningstar Corporate Bond Index has risen to 3.05% from its low of 2.90% at the end of July.
Contrary to the typical August slowdown, the new issue market remained relatively active last week. For corporations for which we issue credit ratings, $17.4 billion of new bonds were priced over the course of the week. Typically, new issuance slows in August, one of the quietest months of the year as investors head to the beach for the final days of summer. However, investors appear to have cash that needs to be put to work and all-in interest expense remain near historic lows, prompting issuers to take advantage of the liquidity and low rates while they're available. This supply was easily swept up, pushing new issue spreads inside where existing bonds were trading in many cases, as investors continue to pour money into corporate bond funds.
As investors discount credit risk, the financial sector (which is the most affected by systemic risk) has outperformed the industrial sector. The differential between the average spread of the financial sector versus the industrial sector in the Morningstar Corporate Bond Index is at it tightest level since July 2011.
Nothing Has Changed Over the Past Month
Credit spreads and sovereign credit risk have rallied strongly over the past month, which causes us to ask, What has really changed? As far as we can tell, not much, other than that investors continue to pour new money into bond funds. Policymakers have been talking tough, yet neither the Fed nor the European Central Bank has taken any concrete actions, or even proposed any new actions, to address slowing economic growth or the long-term financial viability of the peripheral eurozone nations. From a credit perspective, second-quarter earnings reports were generally a non-event, as most firm's credit metrics remained stable, although many management teams provided very cautious outlooks for the second half of the year. Economic indicators in the United States continue to reveal a mixed outlook, and the eurozone economy continues to weaken.
Over the course of the next month, we expect a number of events may cause a disruption in the calm we have experienced. At the end of August, the market's focus will be on Fed chairman Ben Bernanke's speech at the Federal Reserve's annual conference to see if he announces any changes in policy or reveals new plans to improve the transmission of easy monetary policy into the broader economy. In September, Moody's may conclude its rating evaluation of Spain. Moody's placed its Baa3 rating under review for possible downgrade in June and usually concludes its review within three months. Spanish banks continue to increase their borrowings from the ECB as they are essentially shut out of the public capital markets. It's still unclear as to the structure of the bailout offered to the Spanish banks and whether this debt will have to be guaranteed by the Spanish government, which would increase the country's debt/GDP ratio. Negotiations with Greece to allow the next installment of bailout funds should be concluded in September.
While the ECB may eventually purchase sovereign bonds in the secondary market in an attempt to force yields down for Spanish debt, the ECB is prohibited from directly financing governments. Later in September, the credit market's focus will be on Germany's Constitutional Court, which is expected to rule on whether the European Stability Mechanism is allowable under Germany's constitution. The risk is that if Germany is unable to ratify the ESM, it will take the eurozone back to square one in figuring out a way to finance the deficits and maturing debt of the peripheral countries. If the Constitutional Court rules against the ESM, we're not sure what tricks the eurozone has remaining up its sleeve. Further clouding the picture, Moody's announced that it placed the Aaa ratings of several core European countries, including Germany, on negative outlook. This is a wake-up call for many of Germany's politicians and its populace, as it highlights both ongoing and future costs of the eurozone crisis to Germany. A rating downgrade could be enough to sway Germany against supporting future bailout programs.
Sovereign Credit Risk Rallies Across the Core and Periphery
Sovereign bonds Spanish and Italian bonds continued their rally as their yields dropped and credit default swaps tightened across all the eurozone members last week. For example, Spain's 5-year CDS dropped to +477 (its lowest level in over three months), its 2-year bond rallied 46 basis points to 3.74%, and its 10-year bond rallied 45 basis points to 6.46%. In addition, Italy's 5-year CDS dropped to +433, its 2-year bond rallied 34 basis points to 3.06%, and its 10-year bond rallied 11 basis points to 5.79%. Credit default swaps for even beleaguered Portugal rallied as the spread dropped to +727, its lowest level in over a year. Within the core eurozone, German and French CDS levels declined to +56 and +130, respectively, their lowest levels over the past year.
