Widening Investment-Grade Credit Spreads and Rising Interest Rates Lead to Losses
While the S&P 500 has risen about 12% this year and is near its record highs, corporate bond investors have grown relatively more cautious. From the beginning of the year through June 17, the average corporate credit spread in the Morningstar Corporate Bond Index has widened 8 basis points to 148. Combined with the 40-basis-point increase in the 10-year Treasury bond yield over the same time period, the Morningstar Corporate Bond Index has registered a 1.58% loss. Investors in European corporate bonds have fared much better as the average spread in the Morningstar Eurobond Corporate Index has tightened 13 basis points to 126 and the yield on 10-year German bonds has only increased by 20 basis points. This has resulted in a 0.99% gain in our Eurobond index.
Within the Morningstar Corporate Bond Index, the industrial sector has suffered the brunt of the losses this year, widening 12 basis points versus only 3 basis points of widening in the financial sector. Within the industrial sector, the most cyclical subsectors including basic materials, energy and transportation have performed the worst, widening 24, 24 and 16 basis points respectively. The technology subsector has outperformed the most, tightening 7 basis points.
We continue to view the corporate bond market as fully valued at current spread levels. While credit spreads may modestly tighten because of strong demand for corporate bonds during the third quarter, over the longer term, we think the preponderance of credit spread tightening has likely run its course. The tightest spread our corporate bond index has hit since the 2008 credit crisis was registered in April 2010 at 130, just before Greece acknowledged that its public finances were in much worse shape than previously reported, thus triggering the European sovereign debt crisis. The absolute tightest level that credit spreads have reached in our index was 80 in February 2007, the peak of the credit bubble. We don't anticipate returning to anywhere near those pre-credit-crisis levels as an overabundance of structured credit vehicles such as collateralised debt obligations, or CDOs, and structured investment vehicles, or SIVs, were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised. While there have been some reports that a few investors are beginning to re-evaluate investing in CDOs, we doubt that these structures will re-emerge any time soon in any kind of meaningful size. Over a longer-term perspective, since the beginning of 2000 the average credit spread within our index is 176, and the median was 160.
As the Fed continues to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets from which to choose. This has helped the demand for corporate bonds as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. Unfortunately, this action has penalised savers as the Fed has artificially held down long-term Treasury rates and spread-based fixed-income securities clear the market at tighter levels than would otherwise occur. Trying to anticipate the timing of the Federal Reserve reducing its asset purchase programme has dominated in the current environment, but over the long term, fundamental considerations will eventually hold sway. From a fundamental risk perspective, we generally expect corporate credit risk will hold steady over the next quarter, but we recognise that a number of global factors that could hurt issuers' credit strength in the second half of 2013.
Globally, we are concerned that slowing growth in the Chinese economy, along with deepening recessions in Europe and Japan, could pressure cash flow for those issuers with global operations. In the US, Morningstar's director of economic research Robert Johnson expects real GDP growth to average between 2.00% and 2.25% this year. The risk to his view is that consumer spending, which is one of the main drivers of economic growth, may be pressured as incomes stagnate. With all these factors in mind, we recommend that investors concentrate their holdings in those firms that we believe have economic moats (long-term, sustainable competitive advantages) and strong balance sheets that can weather any economic storm. We think that the bonds of issuers with the following attributes will outperform:
- high exposure to US markets, where we anticipate modest economic growth will continue;
- limited exposure to the eurozone, especially the peripheral countries, where austerity measures hamper economic recovery and nonperforming bank loans are increasing;
- exposure to the emerging markets, where economic growth continues to be positive, albeit moderating;
- and companies that have the wherewithal to expand capital expenditures and infrastructure investments to take advantage of competitors that lack the resources to reinvest in their businesses.
Basis Between US Financials and Industrial Sector Credit Spreads Holding Steady
In the second quarter of 2012 we opined that credit spreads for US banks would outperform the broad corporate market. This opinion was based upon our forecast that the credit metrics for US banks would continue to improve over the course of the year. With credit spreads for banks trading wider than equivalently rated industrials, we saw potential for a shift in sentiment toward financials. Our outlook proved correct, as US banks handily outperformed. On March 1, we changed our opinion as we thought unfolding events in Europe may lead to credit spread widening among European bank bonds, which may then lead to widening credit spreads among US banks. As such, we changed to a neutral view on US banks. Since March 1, the basis (or spread between financials and industrials) has held relatively steady.
While we think this basis will remain steady over the near term, we are vigilantly monitoring the increases in nonperforming loans for both Italian and Spanish banks. If their nonperforming loans continue to grow at the current rate, we think it would likely lead the markets to further question the stability of many European banks. As such, if the credit metrics of those Italian and Spanish banks leads us to downgrade our credit ratings, we may consider changing our recommendation on the financial sector to an underweight. While the markets currently appear sanguine regarding Europe's banking and sovereign risks, we continue to hold a sceptical view that Europe's structural problems have been resolved.
Interest-Rate Risk and Inflation
Long-term interest rates have begun to rise, and the 10-year Treasury bond has reached its highest level since April 2011. Nevertheless, even after suffering a 40-basis-point increase thus far this year, they are still near their lowest levels historically. Last quarter, we opined that as long as the Fed continues its $85 billion per month asset purchase programme that the yield of the 10-year Treasury would remain in a range of 1.75% to 2.25%. However, we have cautioned investors numerous times that once the Fed announces its intention to begin tapering asset purchases, interest rates will likely rise 100 to 150 basis points in a relatively short period of time.
Historically, the yield on 10-year Treasury bond has averaged 245 basis points over a rolling three-month inflation rate. Even at the currently low rate of inflation of about 1.00%, the yield on the 10-year Treasury could easily increase an additional 100 basis points to 3.25% to 3.50%. Whether the Fed begins to reduce its asset purchase programme in the near term or medium term, we expect interest rates will continue to rise (barring a significant exogenous shock to the economy) back towards the average real return over inflation. While we expect interest rates will quickly normalise, we are not overly concerned that the rise in interest rates will overshoot too much from historical averages as inflation and inflation expectations have been declining.
The market implied inflation expectation is quickly sliding as Treasury bonds and TIPS are pricing in a higher probability that the Federal Reserve will begin to taper its asset purchase programme in the near term. Our preferred measure of inflation expectations is the five-year, five-year forward inflation break-even rate. This rate rose as high as 3.00% last September after the Federal Open Market Committee announced the beginning of its asset purchase programme, but has since decreased to 2.37%. While this is still slightly above the average since 1998 of 2.14%, it is below the 2.45% average since the beginning of 2010 when fixed-income markets began to normalise after the credit crisis.
We expect global economic growth will continue to be sluggish in 2013, limiting opportunities for organic growth. In order to enhance shareholder value, management teams will likely continue to look for non-organic ways to support their equity prices. We saw a resurgence in strategic acquisitions during 2012 and expect that trend to continue. Depending on how these acquisitions are structured, the credit implications may be either neutral to negative based on the amount of debt and equity used to fund the buyouts. The number of leveraged buyouts in 2013 have thus far been modest as many private equity firms have been more interested in selling many of their portfolio companies in IPOs while the equity market is hot and harvesting gains. However, as domestic banks have rebuilt the capital on their balances sheets we expect their willingness to fund LBOs will increase in the second half of 2013. With capital available from portfolio sales, private equity sponsors have significant amounts of dry-powder and may look to use any pullbacks in the equity market as an opportunity to purchase quality business.
