Given current earnings and economic news, it is now more difficult to argue that we have not hit bottom. We believe the recovery is in its early phase, and the technical support to the Corporate bond market is unabated. We have been advocating an overweight to Corporate Credit since late 2008, and continue to believe spreads will grind tighter. The excess returns over Treasuries for the Barclay’s Corporate Credit Index were 3.84% for July and 17.37% year-to-date.
In last month’s letter, we cited three areas we would be watching in the near term, two of which were the trajectory and magnitude of losses at the banks relative to expectations. The majority of the large domestic banks have reported second quarter earnings. The main take-away from the quarter is that while results were very weak, they were not weaker than expected. In fact, the percentage of “earnings surprises” continues to creep higher since the low point in the 4Q’08 (Exhibit 1). Historically, asset quality deterioration at the banks tends to persist for two quarters after unemployment peaks. Consequently, we expect asset quality deterioration to continue well into 2010, and loan loss provisioning to remain at elevated levels into the foreseeable future. Earnings performance will be weak commensurate with reserve builds, and “noisy” quarters will be the norm rather than the exception going into the first half of 2010. Further regulatory interventions should not be surprising for small banks and even certain regional banks.
Importantly, as bad as this sounds, this is what the market (and AAM) is expecting. CIT was a recent test, as the deterioration has been contained, keeping the risk idiosyncratic instead of systemic. We expect this cleansing process to take place in all industries to various degrees. In Moody’s latest default report (7/8/09), the global speculative-grade default rate was at 10.1% at the end of June. In April, Moody’s had expected this to peak at 14.8% in the fourth quarter this year. This peak estimate has been revised down over the last two months and is now expected to be 12.8%. The twelve month forward estimate has also been reduced from over 10% to 6%.
As you see in Exhibit 2, since 1973, spreads typically peak a year prior to defaults peaking, and the relationship is statistically significant. This is intuitive since investors need to measure risk in order to assign return expectations. Despite soft fundamentals, we expect spreads to continue to tighten, as uncertainties moderate surrounding rating downgrades and ultimately defaults. We continue to favor high quality credits especially certain high quality Financial senior bonds (e.g., GE, Barclays), which are 50-100 bps wide of Industrial/Utility equivalents.
Source: AAM, Moody’s, Barclays
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