The corporate credit market shrugged off the political rhetoric emanating from Washington last week. Corporate credit spreads traded in a narrow range last week, in a relatively directionless market. Spreads had tried to weaken at the beginning of the week but as soon as they started to move wider, traders snapped up those offerings and pushed credit spreads right back down again.
The buy-the-dip mentality is alive and well as portfolio managers are for the most part ignoring the political antics, trying their best to pretend it's not happening. For all of the headlines proclaiming the potential for a default on government bonds after the Treasury reaches the debt ceiling, investors are not placing any probability on a payment default actually occurring. After having been to the brink several times over the past few years only to be saved by a last-minute resolution, investors have been conditioned like Pavlov's dogs to expect an 11th-hour agreement.
Regarding the economic impact of the government shutdown, Robert Johnson, Morningstar's director of economic analysis, wrote, "If they come to a settlement on the debt ceiling and budget issues in the next week or two (and include retroactive pay for government employees), the economy will do just fine." However, he cautions, "A month-long shutdown would likely cut GDP growth by at least 0.5% in a world of 2% growth." Considering the political impact and repercussions of the government shutdown that have already occurred, it appears that the congressional and executive branches will not be able to reach an agreement on a continuing resolution to fund operations in the near term. As such, it appears the most likely course of action will be to resolve both the budget and debt ceiling issues at the same time over the next two weeks.
While the rhetoric in Washington is getting red-hot, volatility in the markets continues to be very low. Since we changed our opinion on corporate bonds a little over a year ago to market weight from overweight, corporate credit spreads have traded in a relatively narrow range. Over the past 12 months, the average spread of the Morningstar Corporate Bond Index has ranged from +129 to +167 and is currently near the middle of that range. The standard deviation thus far this year is a modest 8 basis points versus about 30 basis points in 2012. Credit spreads backed up this summer as investors sold long-term bonds in order to dodge the impact of rising interest rates, but once the rate of increase in interest rates began to slow, corporate credit spreads quickly regained about half of their widening. While credit spreads have only traded within a 38-basis-point range this year, the average annual trading range is 137 basis points over the past 13 years. Even excluding the 2008-09 credit crisis, the average annual trading range is 80 basis points, which is still more than double what we've experienced this year. The average annual standard deviation for the credit spread in our corporate bond index is 39 basis points, or 22 basis points excluding the credit crisis years.
- source: Morningstar Analysts
We continue to believe that from a fundamental long-term perspective, corporate credit spreads are currently fairly valued in this trading range. Across our coverage universe, our credit analysts generally hold a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads generally will probably be offset by an increase in idiosyncratic risk (debt fund mergers and acquisitions, increased shareholder activism, and so on). However, over the near term, with the Federal Reserve's quantitative easing programme providing a steady flow of liquidity into the markets, we expect corporate credit spreads are likely to be pushed towards the bottom of the current trading range.
The new issue market was relatively quiet last week, as only a few issuers braved fighting the negative headlines to bring deals to the market. The transactions that came to market were originally talked at somewhat attractive concessions to existing trading levels, but these whispered concessions mostly disappeared when the deals were priced and the bonds performed reasonably well in the secondary market. The week's crop of successful offerings may give other issuers and underwriters the comfort to bring more new issues to market this week. The new issue window is open, and those companies seeking financing may be better off coming to market before the debt ceiling debate becomes any more convoluted.
