Despite the shenanigans in Washington (or more likely because of them), buyers snapped up single A or better paper last week. Investors sought after the highest-rated issuers, such as Wal-Mart (WMT) (rating: AA), Microsoft (MSFT) (rating:AAA), and Johnson & Johnson (JNJ) (rating: AAA). Early in the week, there was market chatter that Chinese investors were out buying the most highly rated bonds, and the speculation was that those accounts were reallocating from other asset classes such as agencies and Treasuries. Insurance companies were also out in force, searching along the entire yield curve for highly rated issuers.
Indicative of this demand, the corporate bond spread for the Morningstar Corporate Bond Index tightened by 5 basis points last week to +154 and the AA rated component was the best-performing rating segment. The long end of the Treasury curve rallied strongly, as both the 10-year and 30-year tightened about 20 basis points to end the week at 2.80% and 4.13%, respectively. Half of the gains came at the beginning of the week, and the other half occurred Friday after the horrible second-quarter gross domestic product number was released.
High-quality corporate bonds are providing a port in the storm, as investors are comfortable owning the debt of issuers that have transparent financial reporting and significant cash reserves on the balance sheet. It's hard to argue against owning Microsoft bonds at a spread over Treasuries. The company has nearly $53 billion of cash and short-term investments on the balance sheet against $12 billion of debt and provides much greater financial transparency than any sovereign issuer. As we posited in the spring of 2010 when the sovereign debt crisis first reared its ugly head, we think the transparency afforded in corporate issuer analysis as opposed to sovereign analysis will allow corporate bonds to outperform sovereign bonds. At that time, we also wrote that we expected U.S. corporate bonds to outperform European corporate bonds because of the lack of full disclosure by the European banks as to their sovereign exposure and the sovereign overhang of the peripheral nations that would lead to selling risk assets.
Even though all the headlines in the United States revolve around politicians trying to score political points as opposed to resolving the debt ceiling, we recommend that investors keep an eye on Europe. One week after the latest Greek bailout was announced, sovereign credit spreads have begun to leak wider. Portugal's 4.80% notes 2020 gave up most of their gains and are trading only a few points above their lows. Ireland's 4.50% notes 2020, which moved up the most, began to lose some of their gains, and Greece's 6.25% notes 2020 began to bleed wider.
More worrisome, the debt and credit default swaps for Spain and Italy continued to widen out. Spain's 4% notes 2020 fell to 87.75, which equates to a 5.82% yield or +347 spread over German Bunds. At this level, these notes are only 2 points higher than before the Greek bailout. Italy's 4.45% notes 2020 fell back to their lows at 89, resulting in a yield of 6.14% or +384 spread over German Bunds. Although we no longer consider sovereign credit default swaps to be the best indicator of credit risk, the swaps for Spain and Italy widened to +350 and +300, respectively. Considering that these nations are much larger than Portugal, Ireland, or Greece, have significantly more debt outstanding, and consist of a greater amount of the eurozone's GDP, if either one is no longer able to fund itself in the public markets, it would be near impossible for the Europeans to craft a bailout.
