Credit spreads were relatively unchanged over the course of last week. Even though global equity markets pulled back sharply on Wednesday and Thursday as a result of the release of the Federal Open Market Committee meeting minutes, the average spread in Morningstar's Corporate Bond Index traded in a very narrow range and ended last week 1 basis point tighter at +137.
What could shake the credit markets' sanguine disposition in the near term? Risk emanating from Europe may flare up...
The corporate bond market had been lagging the recent run-up in the equity market over the past few weeks and was able to shrug off the week's weaker market tone. The minutes revealed that the FOMC discussed the pros and cons of the ongoing asset purchases, as well as framed a debate around how and when the Fed should discontinue the programme. This prompted concerns that the Fed may withdraw monetary stimulus sooner rather than later. Volatility in the equity market rose (the VIX rose to over 16 from 12.5 before ending the week at 14.5) and commodities (oil and gold) plunged.
Resilience in the Bond Market
One example of the resilience in the corporate bond market was highlighted in the new issue market by 
Morgan Stanley (MS) which issued $4.5 billion of bonds consisting of 3- and 10-year notes. Initial price talk on the 10-year notes was +190, but due to strong market demand the final spread came down to +178. We still think there is room for Morgan's bonds to tighten.
Further underscoring the demand for bonds, in the sovereign markets even Spain was able to issue $2 billion of new 5-year notes at a spread of +317 basis points.
We have viewed the corporate bond market to be fully valued at current spread levels for a while and expect that returns in the corporate bond market will be in the low- to mid-single-digit range this year. In order to generate a higher return, one would have to assume that either interest rates will have to fall below their already-low levels or credit spreads tighten toward the historically tight levels experienced before the 2008-09 credit crisis, neither of which we think will happen.
In the run-up to the 2008-09 credit crisis, an overabundance of structured vehicles such as collateralised debt obligations (CDOs) and structured investment vehicles were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors learned that many of these vehicles did not perform as advertised, and we doubt that these structures will re-emerge. With real interest rates at negative real yields for over the next five years, investors would have to be willing to lock in an even greater erosion of the purchasing power of their assets to drive interest rates lower.
Risks to the Credit Market: Europe, US and China
So what could shake the credit markets' sanguine disposition in the near term?
Risk emanating from Europe may flare up. After the market close on Friday, Moody's downgraded the United Kingdom to Aa1 from Aaa. While this is not a significant event in itself, it may indicate that Moody's is re-evaluating its credit ratings across the eurozone. The greater risk is if this foreshadows Moody's making rating changes in other European sovereign credit ratings, especially those of Spain and Italy. Also, as we've seen before, once one of the rating agencies makes its move, it provides cover for the others to follow. The outcome of the weekend elections in Italy were not particularly clear, but if Silvio Berlusconi wins, he may reverse the austerity measures and overturn the tax increases enacted by incumbent Mario Monti. If so, the international markets may once again become increasingly concerned about the long-term viability of the country's finances.
We are also keeping a close eye on the US economy as consumer spending has been hampered by the payroll tax increase and higher gasoline prices. Wal-Mart Stores (WMT) issued first-quarter earnings guidance below current estimates, mainly driven by a lower comparable-store sales outlook. Michael Keara, our equity analyst who covers Wal-Mart, expects that the core low-income Wal-Mart consumer will be disproportionately affected by the recent increase in the US payroll tax to 6.2% from 4.2%.
We also are maintaining a wary eye on China. Morningstar's Dan Rohr, who covers the basic materials sector, closely monitors the country's economy. Because of its overreliance on infrastructure expansion as its basis for economic growth, the country exerts a considerable impact on raw material prices. Dan sums up his opinion as such: "We question the sustainability and soundness of the recent reacceleration in China, which has been heavily dependent on infrastructure, heavy industry, and real estate and shows little evidence of a shift toward more sustainable consumption-led growth. Investors face two risks in the near term: Beijing may look to take away the punch bowl as it seeks to rebalance the economy, or the debt accumulation that has accompanied the decade-long investment boom will begin to drag heavily on growth."
We don't know what risks will drive investors' behavior over the next few months, but we continue to recommend that investors remain vigilant of these risks in the context of their investment decisions.
