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Corporate Supply&Flows (FEBRUARY 12)

Investors have consistently wished for wider spreads and, at last, the market seems to be of a mindset to oblige.

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CreditSights: The Market Loses Its Mojo

Investors have consistently wished for wider spreads and, at last, the market seems to be of a mindset to oblige. Unfortunately however, the only way to get from current levels to wider spreads is by spreads actually widening, and to the degree that they have done just that since the start of the year, they have more unnerved investors than sent them running to buy the dip.

Admittedly, the "dip" as it currently stands could be passed off as much ado about nothing. But, there is no denying the other evidence of a market that has somewhat lost its mojo. Secondary trading is lackluster with little participation from the buy side and primary market volumes are well down on forecasts. The tone of the market is decidedly more cautious and given the events in other high-beta fixed income sectors since the start of the year, one can hardly wonder at the change. The emerging markets have long been the early harbinger of unraveling risk appetite in the fixed-income sector, particularly if the trades have been fed by leverage and easy access to (very) cheap money. EM has been hit hard in the past few weeks and we would also note that in countries such as Brazil (which was a recent heavy new-issue borrower), it is the external debt that is taking it on the chin. The domestic markets are comparatively stable, suggesting this is not about a re-rating of fundamentals, but rather a reassessment of the technicals that have driven external investment.

Next in the risk appetite food chain is the U.S. high-yield sector, and the data points offered up in that market in the latest week were less than encouraging. The high-yield sector has been supported by heavy fund flows and even heavier issuance for many months now. Both hit a wall in the latest week. With these developments in other sectors, it is not surprising that investors in the high-grade market are sitting on their hands rather than jumping in to those high-beta investment-grade sectors that have shown some meaningful spread widening. The debate has gone on for some time as to whether the sector was fundamentally fair valued or fundamentally rich, but it was an argument that could only continue while the market was technically bid. And, that bid seems to have been erased as quickly as the words "for a considerable period" were erased from the statement that followed the latest Federal Open Market Committee meeting. Only one of those two developments surprises us.

From a fundamental standpoint, little has happened so far this year that we find surprising. Economic data continues to point to a sustainable above-par growth path, with strides being made in the manufacturing sector. Employment growth is lagging the cycle and is hampered, we believe, by structural changes in productivity and domestic versus foreign job sourcing. Earnings season has reiterated the growing health of the corporate sector. Merger & acquisition activity is accelerating. Fiscal policy is showing no signs of restraint. And the Federal Reserve has taken the first steps to acknowledging that monetary policy is not currently just accommodative, it is stimulative, and it does not need to remain so for much longer.

From a technical standpoint, the corporate market seems less able to cope with the change in stance at the Fed than we had imagined. The mere specter of an end to the easy money has proved to be rather disturbing to investors. We do not believe the fundamentals warrant an overly cautious stance and continue to view the corporate sector as the most likely of the fixed-income sectors to benefit from an economic upswing. But, the signs suggest that investor sensitivity to "bad" news is rising. While maintaining our constructive view overall, we believe that a greater degree of prudence may be warranted near term, particularly in the liquid high-beta sectors.

Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.

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