Credit Performance in Europe
The election called into question the willingness of the Italian people to adhere to austerity measures
Credit spreads widened across Europe as the average spread in the Morningstar Eurobond Corporate Bond Index widened 3 basis points to +141. Credit spreads in the European financial sector experienced the brunt of the widening as represented by Markit's iTraxx Europe Senior Financials credit default swap index, which widened 13 basis points. That compares to the iTraxx Europe credit default swap index, representing the broader European corporate bond market, which widened 5 basis points.
The impetus for the weakening in credit spreads in Europe was the result of the recent general election in Italy. The election failed to produce a clear winner and resulted in a potentially unstable government. This normally would not be that large of a concern, but the election called into question the willingness of the Italian people to adhere to austerity measures required by the European Central Bank. There are beliefs in the market that the strong showings from the coalition led by former prime minister Silvio Berlusconi, as well as the coalition led by comedian Beppe Grillo, are essentially a referendum on an antieuro platform. While the antieuro stance in Italy could be exaggerated, the election may have put the problems of Europe back on centre stage as far as the markets are concerned. Italian 10-year bonds widened 50 basis points to a spread of +338 over German bonds.
We remain sceptical that the markets will receive the desired clarity out of Italy in the near term. Even if this is achieved, we think the continuing growth in non-performing loans in Spain and Italy will most likely lead the markets to further question the stability of many European banks. As such, we expect credit spreads of European banks will probably widen, which may then lead to widening credit spreads among US banks. Therefore, we are changing our outlook to a neutral view from the prior opinion that credit spread tightening among large US banks would likely outperform other sectors.
Credit Markets in the US
While there were pockets of weakness earlier last week, credit spreads in the United States were generally unchanged. The average credit spread in the Morningstar Corporate Bond Index closed at +136.
In our view, nothing noteworthy came about from Federal Reserve chairman Ben Bernanke's congressional testimony, and we yawned along the with the rest of the credit market as the sequester went into effect. While the sequester will affect some sectors more than others, we don't expect it will have a significant near-term impact on the credit markets.
In the near term, defence contractors, such as London-listed 
Cobham (COB) and BAE Systems (BA.), will probably be some of the most affected by the sequester, although to varying degrees. From a credit viewpoint, investors may want to give preference to firms with exposure to commercial aerospace and long-lived defense programs as well as those issuers with larger international exposure, which will help soften the blow of US spending cuts. We think firms with higher reliance on information technology will be the most negatively affected by the sequester. Raytheon (RTN) is one of the US leaders for global exposure with 26% of 2012 sales to international customers. Boeing (BA) and General Dynamics (GD) also have global sales at 24% and 21% of revenue, respectively.
We generally don't expect any rating cuts in the foreseeable future for defence businesses since most firms have been diligent in managing their cost structures and keeping their balance sheets strong. Still, uncertainty is significant and 2013 guidance largely excluded any impact from sequestration, so headline risk remains an issue. Investors might consider hiding out in the names with commercial aerospace exposure until clarity on defence spending emerges.
With contributions from Rick Tauber, CFA, CPA.
The original version of this article was published on Morningstar.com.
