It was a holiday-shortened week in the United States last week and traders quickly left for the Hamptons after lunch on Friday, but the action in the interim was fast and furious. High beta bonds tightened 5-7 basis points a day during the week. Positive economic metrics such as renewed strength in the ISM report the prior Friday, better-than-expected same-store sales, and a strong ADP National Employment Report buoyed sentiment. However, those same high beta issues gave back a significant amount of their gains Friday morning after the employment situation report showed abysmal job growth.
A confluence of factors drove credit spreads tighter and faster than we would typically witness. Real-money accounts (considered to be long-term, buy-and-hold investors) were buying bonds as they continue to be comfortable owning credit risk of U.S.-based issuers. Fast-money accounts (such as hedge funds that quickly move in and out of positions) swiftly tried to cover any short positions that they initiated at the end of last month when spreads started widening on sovereign credit fears. Dealer inventories were light going into the week, and investors found that by the time they called dealers to lift offers, many times those positions were already sold. In fact, one dealer saw some trades that occurred off bid-wanted lists that priced through the offer side (meaning investors were willing to buy bonds at a higher price than indicative quotes).
The new issue market didn't help the inventory problem much, as issuance was relatively muted. Several deals appeared to be generated through reverse inquiry, and those bonds are typically tucked away in buy-and-hold accounts and not traded in the secondary market. We continue to expect the new issue market to be subdued; many deals that would have been slated for July were priced in May and early June as low interest rates and tight credit spreads led CFOs to decide to hit the market sooner rather than later. Considering earnings season starts in earnest next week and will last until August--a seasonally slow month because many participants are on vacation--we expect the volume of new issues to remain low until September.
We think volatility in the credit markets will continue for the foreseeable future. Headline risk will continue to emanate from Europe as the politicians and bureaucrats try to figure out how to deal with the debt of the peripheral European nations. In the United States, the clock is running out on raising the debt ceiling. We will be pleasantly surprised if a deal can be completed in the near term (especially a deal such as the most recently reported package, which would cut the deficit by $4 trillion over 10 years). However, we expect the negotiations will go down to the wire before one side or the other blinks. Lastly, economic indicators over the past two months have been mixed and unpredictable. For many of the recently released economic indicators, the consensus forecasts have not only been wrong by orders of magnitude but also have been wrong by direction.
Considering that the underlying fundamentals for U.S. credit risk continue to be sound (credit metrics have generally improved as the preponderance of companies we rate have generated strong free cash flow, increased liquidity, and reduced debt leverage), we think portfolio managers will look to generate extra returns by buying on these headline-induced dips and selling into the subsequent rallies.
