Investment-grade bond spreads compress, but rising interest rates lead to a quarterly loss.
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By Dave Sekera, CFA | 03-27-13 | 06:00 AM | Email Article
  • U.S. financials have finished their run of outperformance.
  • Market implied inflation is moderating.
  • Global economic pressures are adversely impacting credit ratings.

 

Dave Sekera, CFA, is director of corporate bond strategy and a senior securities analyst with Morningstar.

Rising interest rates more than offset modest spread tightening within the Morningstar Corporate Bond Index, leading to a negative 0.44% total return in our Corporate Bond Index year to date through March 15.

The average spread of the Morningstar Corporate Bond Index decreased 7 basis points to 134 basis points above Treasuries; whereas, the yield on the 10-year Treasury bond rose 24 basis points to 2.00%. Credit spreads also tightened across Europe as the average spread within the Morningstar Eurobond Corporate Index decreased 5 basis points to 135 basis points over Treasuries as of March 15.

We view the corporate bond market to be fully valued at current spread levels and expect returns in the low- to mid-single-digit range this year. Currently, the yield on the Morningstar Corporate Bond Index is 2.71%. In order to generate a higher return, one would have to assume that either interest rates will fall below their already low levels, or credit spreads will tighten toward the historically tight levels experienced prior to the 2008-09 credit crisis.

While we think the strong technicals supporting the corporate bond market can push credit spreads slightly tighter in the short run, we don't expect credit spread levels to tighten meaningfully from here. In the run-up to the 2008-09 credit crisis, an abundance of structured credit vehicles such as collateralized debt obligations, or CDOs, and structured investment vehicles, or SIVs, were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised. We doubt that these structures will re-emerge anytime soon. With real interest rates at negative real yields for over the next five years, in order to drive interest rates lower investors would have to be willing to lock in an even greater erosion of purchasing power. We don't expect such an outcome.

Over the second quarter of 2013, credit spreads appear poised to modestly tighten further as strong demand supports the corporate bond market. However, over the longer term, we think the preponderance of credit spread tightening is likely to have run its course. The tightest average spread of our Corporate Bond Index since the 2008 credit crisis was 130 basis points above Treasuries in April 2010, just prior to when Greece admitted its public finances were much worse than previously reported, thus beginning the European sovereign debt crisis. The absolute tightest level that credit spreads have reached in our index was 80 basis points above Treasuries in February 2007, the peak of the credit bubble. Over a longer-term perspective, since the beginning of 2000 the average credit spread within our index is 176 basis points above Treasuries, and the median was 160 basis points over Treasuries.

From a technical perspective, the outlook for the corporate bond spreads couldn't look any better. Demand for corporate bonds remains especially strong as investors continue to pour new money into the fixed-income markets. The new issue market reached record levels in 2012, but yet was still unable to keep pace with investor demand. Dealer inventory in the secondary market also remains near its lows.

As the Fed continues to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets to choose from. This is forcing credit spreads tighter as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. Unfortunately, this action will further penalize savers as the Fed artificially holds down long-term Treasury rates, and fixed-income securities that trade on a spread basis clear the market at levels that are tighter than would otherwise occur. As such, the average yield within our Corporate Bond Index continues to reach new all-time lows.

While technical factors have dominated in the current environment, over the long term, fundamental considerations will eventually hold sway. From a fundamental risk perspective, we see a number of domestic and global factors that could adversely affect issuers' credit strength in 2013.

No matter what resolution is reached regarding the sequestration, we expect the result will be a drag on domestic growth. Globally, we are concerned that slowing growth in the Chinese economy, along with deepening recessions in Europe and Japan, could pressure cash flow for those issuers with global operations. With these factors in mind, we recommend that investors concentrate their holdings in those firms that have long-term, sustainable competitive advantages and strong balance sheets that can weather any economic storm. For the near term, we think bonds of issuers with following attributes will outperform:

  • High exposure to U.S. markets, where we anticipate modest economic growth will continue
  • Limited exposure to the eurozone, especially the peripheral countries where austerity measures hamper economic recovery
  • Exposure to the emerging markets, where economic growth continues to be positive, albeit moderating
  • Companies that have the wherewithal to expand capital expenditures and infrastructure investments to take advantage of competitors that lack the wherewithal to re-invest in their businesses

U.S. Financials Have Finished Their Run of Outperformance
Since the second quarter of 2012, we have opined that credit spreads for U.S. banks would outperform the broad corporate market. This opinion was based on our forecast that the credit metrics for U.S. banks would continue to improve over the course of the year. With credit spreads for banks trading wider than equivalently rated industrials, we saw potential for a shift in sentiment toward financials.

Our outlook proved correct, as U.S. banks have handily outperformed over the past three quarters. However, on March 1, we changed our opinion as we think unfolding events in Europe will likely lead to credit spreads widening among European bank bonds, which may then lead to widening credit spreads among U.S. banks. As such, we changed to a neutral view.

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Dave Sekera, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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