While corporate bond credit spreads appear poised to modestly tighten in the near term, at this point, we believe the preponderance of credit spread tightening has run its course. The tightest average spread of our index since the 2008-09 credit crisis was reached in April 2010 at +130, just before Greece admitted its public finances were much worse than previously reported, thus beginning the European sovereign debt crisis. Since the beginning of 2000, the average credit spread in our index was +177, and the median credit spread was +164.
While the average credit spread contraction has slowed, the demand for corporate bonds has not. The new issue market continued to dominate trade flow because it was the only avenue for investors to find a meaningful amount of bonds to purchase as dealer inventories remain near their lows.
One example of the activity in the new issue market last week is Ford Motor Credit Corporation. The company issued 10-year bonds at a spread of +260 over Treasuries. The original whisper talk was +280, which was subsequently tightened to +265 when official price guidance was released. The issue immediately traded up in the secondary market and ended the week at +235. We were not surprised that the notes tightened, as we think fair value for the notes is roughly +225, but 25 basis points in a day for one of the largest bond issuers is a very significant move over such a short period.
Rushing to Buy
The current environment reminds me of prior periods in the mid-2000s, when demand for corporate bonds became so great that any time a new issue was announced, buy-side traders would place their orders irrespective of price talk and even before checking with their research analysts about the quality of the issuer. These traders knew that if they didn't immediately put in orders for the deal, the chances that they would receive a decent allocation were slim to none, as all of the deals were multiple times oversubscribed.
During one of these periods, a buy-side trader I used to work with changed the tag line on his Bloomberg message screen to "Buy 'em all first, let research sort it out later." He recognised that the market was becoming so hot that even if the portfolio manager didn't want the bonds, the trader could easily flip the bonds into the secondary market and make a small gain as the credit spread tightened a few basis points. This highlighted the fact that fundamentals were taking a back seat to the market technicals as inflows into mutual funds were outpacing portfolio managers' ability to put the cash to work.
Fundamentals Will Overrule in the Long Run
Since the Fed's announcement that it was going to purchase mortgage-backed securities (MBS), the average credit spread of long-dated MBS has reportedly tightened more than 60 basis points. As the Fed ramps up its purchase of MBS and continues Operation Twist (selling short-dated Treasuries and purchasing long-dated Treasuries), investors will have increasingly fewer fixed-income securities to choose from, which in the near term is likely to force credit spreads tighter as this new liquidity looks for a home.
While technical factors have dominated in the current environment, over the long term fundamental considerations will eventually hold sway as there are a number of domestic and global factors that could adversely affect issuers' credit strength during the fourth quarter. For example, in the US, 
Norfolk Southern (NSC) was the latest to announce that its quarterly profit would miss consensus expectations (joining Federal Express (FDX) and Intel (INTC)). The uncertainty and outcome of the US presidential elections and negotiations to mitigate the fiscal cliff will affect numerous sectors, with health care and defence being the most directly affected.
We are also concerned that China's slowing growth and Europe's slide into a recession could pressure cash flows for those issuers with global operations. Gauging the economic outlook of any economy is tough enough, but is especially difficult for China. As such, our basic materials team monitors hard data to measure the resilience of capital infrastructure spending in China (the largest contributor to economic growth). One of the most concerning indicators of a potentially rapid slowdown is the dramatic decrease in the spot price of iron ore, which has dropped from $150 per ton earlier this year to as low as $88.50 before rebounding recently to $109.75.
In Europe, while the European Central Banks' outright monetary transaction program appears to limit near-term sovereign default risk, Spain and Italy are suffering the brunt of the recession, and their sovereign credit metrics continue to decline, which could call into question their long-term sustainability.
Taking everything into account, we advise investors to be cautious in selecting which bond offerings they participate in, lest they be plagued with buyer's remorse if the market takes a turn for the worse. While we understand the pressure to put money to work and the desire to pick up additional yield, we recommend that investors continue to be careful.
