Credit spreads continued to widen last week as investor concerns ranging from systemic risk emanating from Europe to a possible double-dip recession in the United States took their toll on the market. However, the greatest losses occurred after the Federal Reserve released its statement and the yields on Treasury bonds dropped precipitously. Interestingly, all-in corporate yields were close to unchanged as credit spread widening closely matched the tightening in longer-dated Treasury bonds. It appears that investors either have all-in yield targets that they refuse to budge from or that the credit market does not believe that underlying interest rates will stay near their lows for very long.
The Morningstar Corporate Bond Index widened 18 basis points to +243; however, that spread could easily be higher or lower by a few basis points. This was the second-largest weekly change since May 2010, when the sovereign debt crisis first reared its ugly head (38 basis points of widening at the beginning of August was the largest). Traders struggled to discern accurate trading levels as spreads gapped out, often on little to no volume. Trading was especially sloppy on Thursday. Lowball bids were hit, but then as several of the trades were reported, the bid on the follow was higher as investors looked to purchase paper on the cheap. On Friday, the markets were apparently buoyed by rumours that European policymakers would speed up plans to address the sovereign overhang and related solvency concerns for European banks. If the markets trade up on these rumours and nothing is substantiated in the near term, we fear there could be a quick reversal of those gains.
We've long opined that European credit spreads will weaken further and faster than domestic spreads until a comprehensive resolution addresses the long-term structural problems of the overindebted peripheral nations and the solvency of European banks. Once European policymakers offer a plan that we believe appropriately addresses these issues, we will reassess that position. Considering credit spreads in Europe are wider than equivalently rated U.S. issuers, those spreads would probably snap back to U.S. levels in very short order.
We've suspected for a while that policymakers (contrary to their official denials) have been working on a Plan B to allow Greece to fail while supporting the short-term funding markets, increasing the purchases of Italian and Spanish debt, and recapitalising insolvent banks. One thing policymakers have learned in the aftermath of the Lehman Brothers bankruptcy is how to deal with systemic risks brought about by a major restructuring event and provide short-term liquidity to banks when traditional liquidity channels freeze. We expect that the European Central Bank and the International Monetary Fund will continue to finance Greece until those institutions are confident that their contingency plans are ready.
In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor and manage their credit counterparty risk. Compared with 2008, we believe financial institutions and corporations have implemented much stronger credit counterparty risk processes. For example, a credit risk officer we spoke with at one of the larger regional banks said that not only has the bank examined and reduced risk exposure to all of its counterparties, but it has also taken risk management to the second derivative, examining the counterparty risk of its counterparties. Margin requirements are higher and strictly enforced, and individual credit limits are much lower. In addition to the financial sector, many large corporations have greatly improved their own internal credit risk management to monitor customers and counterparties within their own hedging or trading operations. Unlike 2008, the risks from sovereign debt are more easily identified as opposed to the derivative exposures on subprime debt (anyone remember structured investment vehicles, collateralized debt obligations, or CDOs-squared?).
We therefore do not foresee a major systemic collapse stemming from a default of Greece. In fact, default is probably what the market needs to see happen before credit spreads can begin to tighten.
Historical Perspective
This week we've provided a
graph that charts the Morningstar Corporate Bond Index going back to
1998 to provide historical context. Over this period, credit spreads
have averaged +175; excluding the unusual events surrounding the 2008
credit crisis, they would be even tighter. The current spread level is
more comparable with the 2001-02 recession brought about by the bursting
of the tech bubble.
Robert Johnson, Morningstar's director of economic research, does not believe we are heading into another recession. Considering that our number of rating downgrades has outpaced the number of upgrades in the third quarter, we do view credit risk as modestly increasing, but not to the degree that the market has sold off. In addition, after talking to each of our credit analysts, we do not see a significant increase in jump-to-default risk across our coverage universe. It appears to us that a significant amount of the spread widening encapsulates heightened systemic risk emanating from Europe as opposed to increased probability of default due to deteriorating individual issuer fundamentals.
Over the next few weeks, credit spreads are likely to continue to be whipsawed by the ever-changing headlines out of Europe. At these heightened levels, from a fundamental viewpoint, we think credit risk is attractive. However, as the European sovereign crisis plays out, the market may price in increasing amounts of systemic risk that could push spreads further.
In periods of calm, we expect credit spreads will rally tighter as systemic risk becomes less of a concern and investors concentrate on credit risk fundamentals. We advise investors to concentrate on those issuers that we deem to have wide or narrow economic moats and significant balance sheet liquidity to ride out any economic storms.
Dave Sekera, CFA, is a senior securities analyst with Morningstar.
