Credit spreads rallied last week after the agreement was announced that would forestall the US fiscal cliff. The volume traded in the bond market was subdued, but in the more liquid derivatives market, credit spreads quickly tightened 10 basis points. Trading volume of corporate bonds picked up Thursday as several issuers priced multi-billion-dollar deals and short-end buyers came out of the woodwork, lifting offers in the 4- to 5-year maturity range. For the week, the average spread in Morningstar's Corporate Bond Index tightened 5 basis points to +135, near its tightest level since November 2011. Credit spreads in the financial sector tightened 6 basis points, slightly outperforming the industrial sector, which tightened 4 basis points. In our “First Quarter 2013 Outlook”, we opined that the financial sector would outperform the industrial sector this quarter, and we continue to hold that view.
While markets shot up Wednesday in response to the agreement to temporarily resolve the fiscal cliff, the markets have also begun to price in the next battle in Washington. Implied volatility in the equity market has declined substantially since the agreement was announced; however, 31- to 90-day volatility has not declined to nearly the same degree as 30-day volatility. This indicates that the market is viewing little downside risk for the next month, but pricing in greater downside risk as we approach the end of February/beginning of March. That's when we expect the political battles will heat up in the headlines as the US government runs up against the end of the sequestration period and the Treasury runs out of accounting tricks to circumvent the government's need to issue new debt, as the United States reached its debt ceiling at the end of 2012.
We suspect that this week will be busy in the new issue market. While the current agreement in Washington has resolved the tax increases and forestalled the spending cuts under the sequestration, it has addressed neither the fact that the US has already reached its current debt ceiling nor the longer-term issues of spending cuts and entitlement reform. If CFOs are thinking about issuing debt during the first quarter of this year, they would be well advised to tap the capital markets while the new issue window is open, rather than risk trying to come to market after these issues return to the forefront. Once the next political battle heats up in earnest, access to the new issue market could quickly become impaired.
European Sovereign Debt: Back to Normal?
The US markets were not the only risk assets that have priced in a benign short-term political environment. Sovereign debt in the peripheral eurozone is acting as though the sovereign debt crisis has been resolved. For example, Italian bond yields reached their lowest levels since October 2010 and Spanish bonds have reached levels similar to where they were trading last March, before the run-up in their yields as the sovereign debt crisis began. Credit spreads in Morningstar's Eurobond Corporate Index have continued to tighten and are now at the same level as Morningstar's US Corporate Bond Index. The average credit spread in our European Corporate Bond Index had traded as much as 81 basis points wider than our US Corporate Bond Index in November 2011. We continue to be leery of the economic conditions in Europe and don't think the sovereign debt crisis has been fully resolved. As such, we believe investors may want to consider concentrating on issuers with high exposure to US markets, where we anticipate continued modest economic growth.
The original version of this article was published on Morningstar.com, a sister site to Morningstar.co.uk.
