As opposed to the typical August slowdown, the new-issue market remained relatively active last week. For corporations under Morningstar's rating coverage, $21.5 billion of new bonds were priced over the course of the week.
Typically, new issuance slows down in August, as it's seasonally one of the quietest months of the year as investors head to the beach for the final days of summer; however, investors have cash that needs to be put to work, and all-in interest expense remains near all-time lows, prompting issuers to take advantage of the liquidity and low rates while they are available. This supply was easily swept up as investors continue to pour money into corporate bond funds.
The average spread on the Morningstar Corporate Bond index tightened 5 basis points to +176 last week, and the average spread on the Morningstar Eurobond Corporate Index tightened 13 basis points to +190 last week. The average spread within the Eurobond Index continues to be wider than the US Corporate Index, but may continue to tighten faster than the US Index during this cycle of "risk-on" attitude. This could allow for some outperformance by investors with the ability to switch between dollar- and euro-denominated assets. However, for long-term investors, we continue to highlight our preference for US dollar-denominated corporate bonds over euro-denominated bonds, as we still think the problems in Europe are far from over.
One of the reasons that corporate bonds are in such high demand is that as Treasury and Gilt rates continue to bounce around all-time lows, the credit spread has become an increasingly larger percentage of income and total return. For example, with the average spread for BBB+ rated bonds at +165, the amount of income an investor will receive is more than double that of the 10-year Treasury bond at 1.60%. Corporate credit spreads have now recouped all of the widening we experienced since April, when Spanish bonds first began weakening in earnest. In fact, corporate credit spreads are now at the tightest levels over the past year, even though the yields on both Spanish and Italian debt are higher now than in April.
Spanish Debt Gives Back Some of Its Recent Gains
Spanish debt gave back some of its recent gains as the yield on the two-year bond rose 23 basis points to 4.19%, and the yield on the 10-year bond rose 6 basis points to 6.91%, taking the 10-year yield perilously close to breaching the 7% level. While these yields are well below where they peaked in July, they are still trading at a significant spread over where German bonds trade, indicating the market continues to price in a high probability of default. While Spain can roll over maturing debt and finance its deficit for now, if interest rates remain at these levels, the nominal growth rate of the Spanish economy will need to grow rapidly, otherwise these yields will be unsustainable for the country to remain solvent over the long term.
Click the below image to see our summary of recent movements among credit risk indicators.
