How Contagious is It?
The Corporate market experienced a modest pullback in late November driven by credit spread widening associated with concerns surrounding Europe, wiping out the positive excess returns for the month. We reduced our European credit positions prior to the widening, namely regulated entities in the region (Exhibit 1).
Source: Barclay’s; Note: 10-year bonds
We have witnessed European governments not only raising costs for the banks, but non-financial companies as well. For example, in regard to the utility sector, Germany proposed a nuclear fuel tax and Spain postponed its scheduled tariff increase and embarked on a wholesale review of the electricity sector’s costs. Moreover, the Greek government imposed special contributions on Greek profitable entities calculated on their total net income for the fiscal year 2009 based on a progressive scale up to 10% of their total net income. Regulated entities are particularly vulnerable not only due to revenue pressure, but also because they have high operating leverage and are very large employers. Therefore, as revenues are pressured by miscellaneous levies and the sour economy, costs are not easily adjusted to protect profit margins. In addition, credits that benefit from ratings uplift due to sovereign support are experiencing credit rating downgrades as sovereign ratings are downgraded and/or notching is widened (between the sovereign and credit), with support being viewed as less likely given governments’ reduced financial flexibility. Our optimism earlier this year has clearly waned regarding Europe. We await important events this week such as the European Central Bank’s Long-term Refinancing Option (LTRO) full allotment decision and Portugal and Spain debt issuance, but appreciate the market’s concern, which is chiefly how the underlying structural problems will be addressed.
Except for the banking sector and select European utility and telecom credits, we have not witnessed broad based spread widening or systemic risk increasing in the Corporate market. While the stock market has sold off modestly, three-month Treasury-bill Eurodollar (TED) and LIBOR Overnight Indexed Swap (OIS) spreads have remained low (Exhibits 2 and 3). We would expect this to continue unless the market’s fears concerning Spain or other large sovereigns (e.g., Italy) are stoked.
We remain constructive on Corporate credit, but at current spread levels, credit selection is paramount. Spreads for high quality credits are tight, yields are low, and while BBB Industrials are attractive given the stabilization of the U.S. economy (see Exhibit 4), we are investing carefully given our expectation for continued high spread volatility.
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