US Market
The Morningstar Corporate Bond Index ended last week at a spread of 144 basis points, essentially unchanged from the prior week and 6 basis points tighter since the beginning of the year. We believe credit spreads will tighten further over the course of the year as credit metrics and the economy continue to improve. However, credit selection and covenant protection will be extremely important, as we expect private equity funded leveraged buyouts to increase.
Inflation expectations have become a hotly contested issue in the credit markets. Recent economic indicators such as the ISM Index, Purchasing Managers Index, and regional Federal Reserve surveys have revealed an underlying trend in their prices paid components. Morningstar's consumer product team has also highlighted this trend in underlying raw-material costs. As commodity prices skyrocket around the world, interest rates have been steadily rising. Indicative of this concern is the increase in the 10-year Treasury, which rose 30 basis points last week to 3.63%--133 basis points off the low in October 2010 and the highest yield since May 2010. The steepening of the yield curve also suggests that investors are becoming increasingly worried about inflation. For example, the spread differential between the 2-year and 30-year Treasury is currently 400 basis points, the widest it has ever been.
Europe
Sovereign credit spreads gapped tighter across the board on seemingly no new news. Credit default swaps in Portugal, Ireland, Greece, and Spain each tightened by 50 basis points or more over the course of the week. The trading levels are similar to where the credit risk was priced last October before the runup caused by Ireland's credit crisis. Corporate credit spreads in Europe followed this trend and tightened as well. With the pressure being taken off the sovereign credit spreads, the European financial sector outperformed last week and tightened about 10 basis points.
