Is European Central Bank Monetization the Answer?
Corporate Bonds Underperformed Again in November
It did not take investors long to turn cynical, selling risk assets once again in November. Corporate bonds underperformed Treasuries, widening 41 basis points (bps), generating -288 bps of excess returns in November with Financials posting the worst performance (-367 bps) and Utilities the best (-156 bps) per the Barclays Capital U.S. Corporate Index. Similarly, longer duration bonds (10+ year maturities) suffered most with 47 bps of spread widening, producing -566 bps of excess returns. Not surprising, the worst performing issuers included European credits (Telefonica, Telecom Italia, Eksportfinans ASA) as well as credits with heightened credit risk (Amgen, Jefferies).
This did not keep issuers from the new issue market, as November marked the highest month of issuance from Industrial companies ($59 billion), bringing the gross supply for Corporate bonds to a healthy $75.4 billion for the month or $604.3 billion for the year. Net supply is $352.1 billion year-to-date. This reflects lower Financial issuance, as banks in the U.S. are over funded with deposits and European bank issuance is being shunned by the market.
December is starting off well with excess returns of 71 bps month-to-date as of December 9, 2011 per the Barclays Capital U.S. Corporate Index. That said, the lack of real progress made at the latest European Union (EU) Summit will likely result in waning performance through year-end as liquidity worsens.
Little Solved at the Summit Leading to Negative Rating Agency Press
The statements made from the European Central Bank (ECB) and European Banking Authority (EBA) were among the most scrutinized. The ECB announced that it would substantially increase its liquidity provision to EU banks in order to avoid a liquidity crunch. Included in the announced measures were unlimited three year funding (via its Long Term Refinancing Operation), relaxed collateral requirements, and a target rate cut for good measure. What was not included was a ramp-up in outright sovereign bond purchases through the Securities Market Program (SMP). In fact, European Central Bank President Mario Draghi explicitly repeated that the ECB would not act as the back-stop lender to the sovereigns, and he re-emphasized that it was up to the national leaders to come up with a fiscal solution to a fiscal problem.
The seventeen Euro members agreed in principal to a new treaty, outside of the framework of the existing EU treaties which preceded them. The new treaty would enshrine greater fiscal integration and automatic penalties for those that violate budgetary rules (to be administered by the EU bureaucracy). Specific details will be forthcoming by March 2012, and nine of the ten non-Euro members of the EU will likely also be signatories to the new proposed treaty (the United Kingdom has explicitly rejected further integration, very much in keeping with past precedent, citing encroachment on its sovereignty). Additionally, the EU central banks also agreed to contribute €200 billion, via the International Monetary Fund (IMF), in order to supplement the remaining capacity in the European Financial Stability Facility (EFSF), which was roughly €250 billion. Lastly, the EU leaders agreed to move forward the debut of the permanent replacement for the EFSF, the €500 billion European Stability Mechanism (still unfunded).
Standard & Poor’s and Moody’s reacted negatively to the Summit by reiterating their views that Eurozone countries could be downgraded by the end of first quarter of 2012 due to politicians’ inaction in the face of rising constraints, increasing the risk of adverse economic conditions. Specially, Moody’s stated:
The announced measures therefore do not change Moody’s previously expressed view that the crisis is in a critical and volatile stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While Moody’s central scenario remains that euro area will be preserved with out further widespread defaults, the shocks that are likely to materialize even under this ‘positive’ scenario carry negative rating implications in the coming months. Moreover, the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.
The timeframe imposed by the rating agencies for policy initiatives in the near future that stabilize credit market conditions effectively is too aggressive in our opinion, which increases the risk of rating downgrades and hence the risk of further shocks.
Liquidity is Important but Solvency is Critical
While the support by the ECB is a positive for the banking sector and we look to the ECB for eventual monetization of sovereign debt, it is not a panacea if sovereigns are insolvent. We are increasingly more concerned about the trajectory of Italy and Spain not to mention Greece, Portugal and Ireland (bank related debt specifically). The Financial Times highlighted the risk of low growth and high debt in an article in late November, pointing out that with borrowing costs of 4% and debt/GDP of 120%, Italy needs to grow at 4.8% just to avoid increasing its debt burden when it has a balanced budget. At 2% growth, its budget surplus will have to be 5% per year for 10 years to reduce its debt/GDP to 90% or begin to sell state assets. Even Germany will need to grow at 2.4% to avoid increasing its debt levels, and France even higher. This problem becomes worse as liabilities are increased to fund weaker EU members. We remain concerned that without true fiscal integration, the stop gap measures taken by the politicians and/or ECB will not appease the markets, increasing the risk of default at the credit and/or sovereign level.
AAM’s Corporate Investment Strategy is Defensive
We took advantage of the short lived rally to further reduce our holdings in Financials, a sector that will continue to ebb and flow with the news emanating from Europe. Our investment thesis is that Europe will remain volatile and the ECB will be forced to step in and monetize sovereign debt. At this point, our base case does not assume a departure from the EU, but we are aware that the risk is increasing. We expect lower than expected economic growth for Europe, as banks shrink their balance sheets to meet new capital requirements, governments become more austere and investors look outside of Europe to invest. Therefore, we continue to avoid European credit and invest in higher quality, liquid credits exposed to the U.S. and growing Asian and Latin American countries. At this point, we are comfortable with the economic landscape in China, but are watching that closely, cognizant of the ties the country has to Europe and domestic construction activity to fuel its growth.
Elizabeth Henderson, CFA
Director of Corporate Credit
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.
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 Eksportfinans ASA was downgraded to Ba1 from Aa3 by Moody’s after the unexpected decision by the Norwegian government to wind it down.
 Jeffrey Meli, “November 2011 U.S. Credit Index Performance” ,Barclays Capital Credit Research: U.S. Investment Grade Corporate Update, December 1, 2011, page 2.
 Alastair Wilson, “Moody’s: Euro Area Sovereigns Remain Under Pressure In Absence of Decisive Initiatives” Moody’s Investor Service Announcement, December 12, 2011, http://www.moodys.com/research/Moodys-Euro-Area-Sovereigns-Remain-Under-Pressure-In-Absence-of–PR_233208, accessed December 12, 2011.
 Das, Satyajit, “Low Growth and High Debt is the Sovereign Curse,” Financial Times, November 28, 2011, http://www.ft.com/cms/s/0/aba480e4-110b-11e1-a95c-00144feabdc0.html#axzz1gQwwwIai, Accessed November 29, 2011.