Corporate bond trading desks reported that activity was brutally quiet last week as the August doldrums finally settled in. New issue activity was virtually nonexistent, and secondary trading was tough to come by, as it became increasingly difficult to source bonds and inventory on dealer desks remains near its lows. Credit spreads were largely unchanged over the course of the week, as the few issuers that experienced idiosyncratic weakness were offset by continued demand across the rest of the market.
Underlying market technicals continue to support corporate bonds, even though rumblings of renewed risk—emanating from a weakening global economy and systemic risk from sovereign issues—are sounding closer as we approach September. Treasury bonds regained some of their appeal last week, driving prices back up as the yield on the 10-year and 30-year bonds dropped 16 basis points to 1.66% and 2.77%, respectively.
Clients that we met with last week mentioned that they still have abundant amounts of cash that they need to put to work. However, most are very cautious about adding additional risk into their portfolios and have been looking to trade up in quality. With the dearth of offerings available, many portfolio managers have begun to take the opportunity to clean up their books and offer out for sale bonds of those issuers to which they want to reduce exposure.
Storm Clouds Gathering on the Horizon
Federal Reserve Chairman Ben Bernanke is scheduled to speak at the annual Federal Reserve conference in Jackson Hole Friday, where many pundits expect him to allude to additional quantitative easing and new monetary policy programmes intended to jump-start economic growth. If Bernanke does hint of new or additional monetary easing, the consensus among the clients we have recently spoken with is that it will provide a short-term boost in asset prices, but additional policy actions probably will not have much of an effect on the broader economy. As one client recently put it, the monetary spigot is already wide open, and opening it any further will only drown the markets with cash.
In addition to Bernanke's speech, Italy is scheduled to conduct several bond auctions that could test the depth of the European sovereign debt market to absorb additional peripheral debt. Further testing the market's appetite for peripheral debt, Spain is scheduled to return to the debt markets and price a new bond issue the first full week of September.
By mid-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 German constitutional court rules against the ESM, we're not sure what tricks the eurozone has remaining up its sleeve.
Assuming the ESM is constitutional under German law, the market will focus on the plan and structure to bail out the Spanish banks. Spanish banks continue to increase their borrowings from the European Central Bank 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. In conjunction with uncertainty around the impact of a Spanish bank bailout on Spain's credit quality, Moody's may conclude its rating evaluation of Spain. Moody's had placed its Baa3 rating under review for possible downgrade in June, and we are approaching the three-month window in which Moody's usually concludes its rating reviews. Also, the ongoing negotiations with Greece to allow the next instalment of bailout funds should be concluded in September.
