Corporate credit spreads began to widen out last Thursday morning, accelerated higher in the afternoon, and continued to widen all day Friday. Wall Street traders were long and wrong and had a difficult time finding buyers, even though all-in yields were much higher due to the rise in interest rates. The 10-year Treasury bond widened 15 basis points, ending the week at 2.16%, its highest level since April 2012. Since the beginning of the year, the 10-year has widened a total of 40 basis points. Traders complained that the price action in the corporate bond market felt extremely poor, as buyers were too timid to bid for bonds as interest rates rose rapidly. Investors who did venture into the waters to buy bonds were immediately offered more and often at lower prices, forcing them to mark down the bonds they just bought. Despite recent declines, the S&P 500 Index has gained 14.3% so far this year, whereas the average spread in the Morningstar Corporate Bond Index widened 4 basis points to +137, which takes us to the same level as we began the year. Morningstar's European Corporate Bond index widened 2 basis points to +116, which is 24 basis points tighter for the year.
Interest rates have begun to rise as the market is pricing in an increasing probability that the Fed may begin to taper off its asset-purchase programme within the next few months. We have cautioned investors numerous times that once the Fed announces its intention to begin tapering, interest rates will probably rise 100-150 basis points in a relatively short time. The below chart illustrates that the yield on 10-year Treasury bonds has historically averaged about 200 basis points over inflation. However, as Treasury rates begin to meaningfully surpass the dividend yield of the S&P 500, we expect the pace of rising interest rates will slow as the higher rates attract new investors, especially those who had been allocating assets into high-dividend-paying stocks as a substitute for fixed-income investments.
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OECD Reduces Its Global GDP Forecast, Citing Further Deterioration in Euro Area
The Organisation for Economic Co-operation and Development cut its global 2013 GDP estimate to 3.1% from its 3.4% forecast it made last November, due to further deterioration in the euro area. The OECD reduced its forecast for the euro area to a 0.6% contraction from its prior forecast of a 0.1% contraction. Within the euro area, it expects German GDP to rise 0.4%, French GDP to decline slightly, Italian GDP to decline 1.8%, and Spanish GDP to decline 1.7%. In the rest of the world, it lowered its US GDP forecast to 1.9% from 2%, increased its outlook for Japanese growth to 1.6% from 0.7%, and forecast Chinese GDP growth of 7.8%, a reduction from its previous forecast of 8.5%.
Highlighting the economic deterioration in the euro area, Eurostat reported that the unemployment rate in the euro area for April 2013 rose 10 basis points to 12.2%, an increase of 1 percentage point from a year ago when the unemployment rate was 11.2%. Within the overall unemployment rate, the youth (under 25) unemployment rate was significantly worse, rising to 24.4% from 22.6% a year ago.
Spanish Banks Increase Holdings of Spanish Government Bonds
Prices of Spanish bonds have held up extremely well this year in the face of weaker economic data and persistently high deficits. Partially explaining this phenomenon, the Financial Times reported that Spanish banks increased their holdings of Spanish government bonds by more than 10 % in the first three months of this year. Bank holdings of Spanish government bonds rose by EUR 25 billion to EUR 225 billion as of March 2013. The FT further reported that as a percentage of the total amount outstanding, Spanish banks' holdings increased to more than 40% from 38%. If the demand from the Spanish banks were to subside, or if the banks needed to sell assets to raise capital, then the yields on Spanish bonds could rise quickly, jeopardising the country's ability to finance its deficit in the public markets at sustainable rates.
