The average spreads in Morningstar's Corporate Bond Index and European Corporate Bond Index held steady last week at +192 and +222, respectively. However, lack of volatility in these indexes masked an undercurrent that many traders are feeling in the corporate bond market.
While the surface appears calm, underneath the placid waters investors are beginning to re-evaluate several concerns that had previously been assuaged. These include rising interest rates in Spain and Italy, which may foreshadow sovereign and banking risks in Europe; softer-than-expected economic metrics in the United States, which may portend weaker growth at home; and deceleration in emerging-market growth, which may indicate a harder-than-expected landing in China's economy.
Until we gain additional clarity on these three topics, we believe a neutral stance is warranted. If the situation in Europe deteriorates, growth in the US dwindles, or the emerging markets descend into a hard landing, the contagion from heightened credit risk will affect the corporate bond markets and spreads will widen across the board. However, if we gain additional visibility that these issues are alleviated, then we think corporate credit spreads will resume their tightening trend as stable corporate fundamentals and positive technicals provide greater demand for corporate bonds.
Spanish Yields Heighten Market Sensitivity to Sovereign Risk
The sovereign debt crisis in Europe is heating up as Spanish yields have risen. Last week all eyes were on Spain's 10-year bond auction, which appeared to be relatively successful as it priced at 5.74% with a respectable bid/cover ratio; however, once the auction was completed, it appears that the markets lost interest following where the bond was trading. Soon after the auction, the 10-year bond began to slide and investors who bought the bond in the auction immediately lost money. By the end of the week, Spain's 10-year bond was back up to 5.96%, again bumping up against the 6% mark where the markets infer that the country is no longer able to sustainably finance itself.
As we previously noted last week, the shape of the curve has remained relatively stable as the spread between the 2-year and 10-year bond has held its range in the mid-200s. This indicates to us that the bond markets are not yet pricing in near-term or jump-to-default risk. Spain is not scheduled to return to the market with another long-dated bond auction until July, which may provide enough time for the country to implement further structural reforms and regain investor confidence.
Sovereign credit default swaps (CDS) generally widened across the board last week. For example, Italy's 5-year CDS rose almost 40 basis points to +475, Spain's 5-year CDS remained near its record high over +500 basis points, and even France rose to more than +200 basis points.
Recent reports have highlighted how Italian and Spanish banks have used the European Central Bank's 3-year long-term refinancing operation program to purchase government debt of their home countries. This carry trade initially brought down yields in those countries and provided enough liquidity to absorb the deposit flight from their banks. This liquidity also provided the Italian and Spanish banks enough capital to purchase their governments' bonds from investors in other countries who have been reducing their exposure to Italy and Spain. The decline in interest rates initially soothed market concerns, but yields bottomed out in early March and have been rising to rates that are reigniting sovereign fears. Last week, several news articles reported that Italian and Spanish banks have used up most of the money they borrowed from the ECB under the LTRO and have little left to purchase additional government debt. If these banks have run out of room to support current bond prices and foreign investors continue to sell down their holdings, the ECB may have to provide even more liquidity, lest yields spiral upward.
Adding fuel to the fire, the Bank of Spain released a report that delinquent loans held by Spanish banks are continuing to rise and have reached 8.16%. This is an increase from 7.91% reported the prior month and almost 200 basis points higher than the 6.20% delinquency rate reported in February 2011. While austerity measures are needed to reach the government's goal to cut the budget deficit this year to 5.3% from 8.5%, these measures continue to depress growth in the near term. As property and home prices decline further across the country, economists fear that delinquent loans among construction companies and households will climb higher.
Following Spain's admission a few weeks ago that it would not make its original deficit reduction targets, Italy announced that it will miss its deficit reduction targets as its economy is slowing more than expected. The Italian government has forecast its GDP will decline 1.2% this year, double the 0.5% decline it had predicted last December. It expects GDP will begin to grow again by 0.5% in 2013. This pushes back Italy's plan to achieve a balanced budget by one year to 2014.
Apart from the financial concerns in Spain and Italy, political risks are rising in Europe. On Sunday, France held the first-round election for its next president, which has significant implications within the eurozone. The leading socialist candidate, Francois Hollande, has run on a platform calling for a renegotiation of the fiscal pact agreed to last December by European Union leaders. If Hollande were to win the presidency, it would probably have considerable ramifications for current German-French relations and require new agreements to keep the EU together. Neither current President Nicolas Sarkozy nor Hollande won more than 50% of the votes in the first round, which means they will enter a runoff election in early May.
Investors Re-Evaluate US Growth Expectations Based on Lower-Than-Expected Economic Indicators
Many economic indicators in the US released over the past few weeks have been below expectations. For example, last week jobless claims of 386,000 were significantly higher than expected, existing home sales of 4.48 million missed the 4.62 million expectation, and the Philly Fed and Empire State Manufacturing surveys were significantly below consensus. One bright spot is that retail sales growth came in at 0.8% compared with consensus expectations of 0.3%. While consumer sentiment has generally been morose, it has not stopped American consumers from reaching for their wallets.
Growing Evidence of Slowing Growth Among Several Emerging Markets
Growth in emerging markets continues to show evidence of slowing. Last week, we highlighted that the growth rate of China's GDP in the first quarter had slowed more than expected to 8.1%. This week, Brazil once again cut its short-term interest rate to 9.00% from 9.75%. This is Brazil's sixth cut since its short-term interest rate peaked at 12.50% in July 2011. India also cut its short-term rate to spur its economy. India reduced its short-term rate to 8.00% from 8.50%, where it peaked last October. This is the first time that India has cut its rate since early 2009. Considering both of these economies are already battling inflation, it reveals the level at which those central banks are more concerned about a slowdown in growth than inflation.
