C.M.O. 12.31.2009
Credit Market Overview
December 31, 2009
On Monday of this short week I discussed the goings on in China and other parts of Asia, Tuesday’s topic was Western Europe and yesterday, the burgeoning trend of the states going outside of the “States” to issue debt.
In closing the week, the month, the year and the decade I thought it would be good to try, in this short space, to sum things up and maybe take a look at what that sum adds up to.
Credit spreads, at each level from micro to macro, are influenced by the changes in the financial condition of the entity to which those spreads apply. That influence, however, is a bit of a self fulfilling prophesy as the basic tenets of supply and demand affect where paper is issued with regard to its spread above a particular benchmark while that feeds back into the loop of where the existing paper trades.
Underlying all of this is where rates, in general, are moving as higher rates will eventually filter through to higher borrowing costs which then raises operating costs and weakens profitability.
In the short term, a move up in rates tends to compress spreads as there is a lag between the more liquid Treasury market and the less liquid corporate or municipal markets. It is important, therefore, to keep in mind the general rate environment when examining credit spread movements.
To that end a recent survey of the 18 primary dealers (Those entities that trade directly with the Federal Reserve and underwrite Treasury auctions.) said that the yield on the two-year Treasury note is expected to end 2010 at 1.825% (the highest since 10/08) vs. 1.08% last night and the ten-year is expected to close the first year of the next decade at 4.125% (the highest since July ’08) vs. 3.789% last night.
Stephen Stanley, chief economist at RBS Securities, gave the following as the rationale for his outlook. “Growth will be quite strong and we are going to get pretty solid employment growth, which is going to translate into a little bit [of an uptick in inflation]. That is going to force the Fed into pushing policy back closer to a normalized rate.” The “normalized” rated SS is talking about is the five year average yield for the 10-year note of 4.1%.
In light of this a number of investors see issuance of corporate debt starting the year off fairly strong but then tapering off as absolute rates being to rise. “Between now and call it, June, we think interest rates remain low”, after that however, Chaka Patterson, treasurer for Exelon (EXC) says, the interest rate picture is “obviously more murky”. EXC sold 10-year and 30-year paper this past September to redeem other notes that were set to mature in 2011.
As of mid-December investment grade issuers sold more than $1TN worth of bonds and the high yield market saw $143BN in issuance. “This year, we saw a lot of people come to market to refinance themselves in earnest, and that will continue next year”, was how Jeff Houston, a senior PM at American Century Investments sees it. Jeff also believes that the refinancing wave was “front-loaded” as many raced to issue paper after the credit markets thawed but before rates rose.
This time of year is full of reviews of the past and attempts to see into the future. Many did not believe the S&P would be anywhere close to the 1126.42 level it closed at last night and few would have imagined a yield curve as steep as the 271bps level currently separating the 2-year and 10-year Treasuries.
2008 and 2009 saw multiple instances of correlations pinning themselves at 1.0 as various programs by two administrations sought to ameliorate the effects of decades of mis-guided housing policies.
They say that life is a journey not a destination. This cliché can be applied to investing as well, as it is often less important where you land up and usually more important how you get there.
I would like to wish everyone much luck and success in 2010. If Uncle Sam can keep his hands off the controls for at least part of the year, that should be much easier for all of us to achieve.
Happy New Year!
Jim Delaney
