The average credit spread in the Morningstar Corporate Bond Index widened 3 basis points last week to +136. Markets softened as a steady stream of disappointing earnings and downward guidance from US companies badgered investor sentiment. However, stronger-than-expected economic metrics along with continued technical factors have largely helped to offset a significant widening in credit spreads.
Portfolio managers are sharpening their sell lists as their trigger fingers become increasingly itchy.
In a completely unscientific poll of clients we met with over the past three weeks, portfolio managers appear to be driving their portfolios with one foot on the brake and one on the gas. While strong market technical factors continue to drive the corporate bond market in the short term, portfolio managers are attempting to balance the desire to maintain enough risk exposure to match corporate bond index returns. However, they are sharpening their sell lists as their trigger fingers become increasingly itchy.
Our conversations were evenly balanced between investors who have begun to modestly sell into the market's strength and reduce the size of their riskiest positions and investors who continue to reach for more volatile and higher credit spread investments in order to ride the risk wave.
The most common question we heard was: How much further can these technical factors drive credit spreads tighter? Based on this uncertainty and market positioning, there could be a significant amount of selling pressure if a catalyst pushes investors to derisk their portfolios. After next week's US presidential election, we expect the news flow will focus on how the outcome of the election will affect the negotiations to resolve the US fiscal cliff and pending debt ceiling.
We continue to recommend tilting portfolios towards defensive positions and undertaking risk in those cyclical issuers whose bonds have gapped out after reporting weaker-than-expected earnings. Investors should be able to outperform by underweighting those cyclical issuers whose bonds continue to trade at relatively tight spreads but have not yet reported earnings. By keeping one's powder dry, investors will have opportunities to take advantage of post-earnings spread widening as additional cyclical companies report disappointing earnings. As always, we recommend sticking with those issuers that we deem to have a wide or narrow economic moat, identifying those issuers that have long-term, sustainable competitive advantages.
Technology Sector Underperforming Due to Low Capital Investment Spending
The technology sector underperformed the general credit market last week, widening out 5 basis points, and it is the weakest sector month to date, having tightened only 1 basis point as compared with 20 basis points for the index as a whole.
In our fourth-quarter outlook for the technology sector, published at the end of September, we opined that declining business capital expenditure spending would disproportionally affect this sector. Third-quarter earnings have been weak largely across the board. A diverse group of firms have disappointed investors, including bellwethers like 
International Business Machines (IBM), EMC Corporation (EMC) and Google (GOOG).
We question AMD's ability to meet its financial obligations over the next few years.
Highlighting the risk of investing in firms that lack an economic moat, especially as business conditions become unfavourable, we sharply cut our credit rating on Advanced Micro Devices (AMD) this past week. The confluence of weak economic conditions, a growing base of substitutes for traditional PCs, poor execution, a weak competitive position, and a relatively shaky balance sheet have placed the firm in a precarious position. AMD is undertaking a restructuring designed to bring its cost structure in line with current demand while also trying to diversify its product line away from the traditional PC market. These two initiatives seem to be at cross purposes, though, and we now question the firm's ability to meet its financial obligations over the next few years. Under our base-case scenario, we project AMD will end 2013 with a bit less than $700 million in cash, far less than management's $1.1 billion target. Under this scenario, cash flow returns to positive territory in 2014 and beyond, but the firm would struggle to meet its 2017 maturity without raising additional capital. More important, our base case leaves AMD with little margin for error during the next few years. In our bear-case scenario, which assumes the current slump in demand cuts only slightly deeper than our base case, AMD would be unable to service its 2015 maturities without raising cash.
