Our Outlook for Credit Markets

Quarter-End Insights: As risks from the European debt crisis subside, we expect corporate spreads will tighten

Dave Sekera, CFA 27 March, 2012 | 4:30PM
Facebook Twitter LinkedIn

Credit Spreads Should Continue to Tighten
Last October, we highlighted that corporate credit spreads were cheap on a fundamental basis, and the corporate bond market has rallied significantly since then. We expect corporate credit spreads will continue to tighten. Near-term systemic risk emanating from Europe has declined substantially, and we forecast that corporate credit metrics will generally hold steady this year.

The fear of systemic risk within the European financial system was alleviated as Greece successfully pulled off what is essentially an out-of-court bankruptcy restructuring. Although some holders of Greek foreign-law bonds tried to threaten the deal, they were unable to subvert the exchange of existing Greek debt for new bonds with a lower principal amount and longer maturities. Greece implemented collective action clauses it had embedded in its bonds, causing the International Swaps and Derivatives Association to declare that a credit event had occurred, but the auction on March 19 to settle outstanding credit default swaps was uneventful and did not lead to any disruptions in the bond markets.

In addition, at the end of February, the European Central Bank (ECB) conducted the second round of its long-term refinancing operation (LTRO), in which it lends money to banks for three years at a rate of 1%. Under the LTRO, the ECB has lent out a total of EUR 1 trillion. While the long-term effect of the LTRO is unknown, in the near term it has assuaged the imminent liquidity concerns among European banks, which were closed off from the capital markets last fall.

As near-term refinancing risk declined, credit spreads for European banks tightened dramatically, driving much of the outsize returns in Morningstar's Eurozone Bond Index. Subsequent to the LTRO, interest rates among several peripheral European nations have declined substantially as this liquidity has sought higher-yielding assets. For example, since the first LTRO last December, yields on Italy's 10-year bond have dropped below 5% from 7%. While near-term liquidity will not solve long-term solvency problems, it has provided policymakers with more time to address the structural sovereign issues and the related solvency concerns regarding European banks.

With a Greek default off the table and the liquidity from the LTRO supporting European banks, near-term systemic risk originating from Europe has declined substantially. Over the next month or two, as investors focus on issuer-specific fundamental credit risk analysis as opposed to systemic risk, we think corporate credit spreads could tighten another 30 basis points, taking the market back to April 2011 levels. Generally, we think that corporations are healthy, credit metrics are stable, and our outlook for credit risk is positive.

Over the longer term, though, investors will need to evaluate how much a potential slowdown in the growth of emerging markets will impact the developed markets. For example, China recently reduced its target GDP growth rate by 50 basis points to 7.5% and reported a stunning trade deficit in February. Chinese exports, especially to Europe, have declined significantly. In addition, Brazil unexpectedly lowered its short-term interest rates by 75 basis points to 9.75% and reported that fourth-quarter GDP growth decelerated to 1.4%, lower than the 2.7% the country reported for the full year. Political risk could also rear its ugly head again as French elections late in April could alter French-German relations if President Nicolas Sarkozy were to lose the election to the Socialist party's candidate. These are all important factors to consider when making credit investment decisions.

To read about Morningstar's outlook for equity markets, click here.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Dave Sekera, CFA  is a senior securities analyst with Morningstar.