CreditSights: The Week In Credit
Despite the fact that the corporate index option adjusted spread actually tightened further in July, when returns are considered then the nine month rally in credit markets came to an end as the sector was unable to post significant excess return to Treasuries. What will hit the headlines (as well as the value of portfolios) however, is that both corporates and Treasuries posted the worst monthly total return performance in nearly two decades given the stunning reversal in interest rates that occurred during the month. July's total return for the corporate index was -4.22%, only a smidge better that the -4.24% posted by Merrill Lynch's U.S. Treasury Master index.
There is strong evidence of a reduction in risk appetite in the market. Given the seasonal timing (August has never been a great month for liquidity) and the first-half performance that managers and street traders alike are keen to protect, the move to step back and hunker down is not surprising. Traders are reporting relatively little real money activity despite the large yield swings Daily moves the likes of which we have been seeing in Treasuries make for markets that are not for the faint of budget.
This may prove to be a relatively brief phenomenon as a continuation of the kind of volatility we have experienced in the last month is not likely. However, we do think it highly probable that we passed the nadir of the multi-year interest rate cycle in June and that the trend higher in yields will continue. In the stand off between the equity market's optimism that a resurgent economy would justify higher valuations and the bond market's belief that patchy demand and abundant capacity created a lack of inflationary pressures that would provide continued support for a super-low yield environment, the decision is in. The stock market may not have been able to run further with its theory but the bond market has had to give up altogether on its. With absolute yields having already made such a substantial adjustment however, continued selling at the current pace is not justified. But while risk appetite may return when the markets stabilize, to what degree will absolute appetite?
Fixed income has been the investment class of choice for two and a half years now. According to the Investment Company Institute, flows into mutual bond funds outpaced flows into equity funds by $44 billion in 2001 and by a stunning $150 billion in 2002. Even as the equity bear market came to an end, in the first half bond funds still garnered $31 billion more than stocks. It is hard to see this trend continuing in an environment where rising yields cause bond funds to post minimal, if not negative, total return. As the fear of a deflationary recession spiral recedes investors are likely to once again shift their focus away from return of capital and back to return on capital. Although the additional spread offered by the corporate sector and its potential to benefit in a more positive earnings environment should insulate it from this trend to some degree, investors should note that the credit markets were a major beneficiary of the inflows and cannot help but be affected should they reverse. Historically the pattern has been that outflows from fixed income funds do not begin until the quarter after the Federal Reserve begins to tighten. But already AMG Data has reported that in July, investment-grade and high-yield funds combined tallied just $326 million in inflow. The monthly average for the last 18 months has been over $4 billion. Although it is early days yet to make a judgment we could be seeing earlier redemptions because of the extremely low level of yields reached in this interest rate cycle and the severity of capital losses inflicted in the sharp rate reversal.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.