Short-dated U.S. government debt prices fell to session lows on Tuesday after remarks from Richmond Federal Reserve President Jeffrey Lacker suggesting the central bank should scale back its $600 billion bond purchase program. Given the recent data which points towards the footings of a recovery, I would expect we will hear more about scaling back QE2 which will continue to result in pressure on the front end of the curve.
Shorter-dated German bonds underperformed longer maturities on Tuesday with euro money market rates expected to come under renewed upward pressure after a low take-up of European Central Bank loans drained excess liquidity. Commercial banks borrowed a total of 218 billion euros from the central bank's weekly and one-month tenders, less than the amount expiring and resulting in a 66 billion euro drain of surplus funds. The liquidity taken out of the system does not help support fund raising by EU members and/or the Euro. Should this continue, we should expect pressure on front end rates and the currency.
Moody's Investors Service said its measurement of debt defaults worldwide fell to 2.8 percent in January, a marked improvement form the 12.6 percent rate a year earlier. For the first time since 2007, Moody's said, none of the corporate debt issuers that it rates defaulted during the month. By comparison, there were eight corporate defaults last January. The January default rate was down from 3.2 percent in December. The ratings agency said the monthly decline in defaults is part of a gradual improvement in credit markets that should continue through 2011, although debt-laden European governments like Spain and Ireland could endanger the outlook. "We continue to expect stable, low default rates for the near future," Albert Metz, Moody's director of credit policy research, said in a statement. But Metz warned that if lenders become jittery and financing dries up again defaults could rise, particularly in Europe. For January, the U.S. speculative-grade default rate fell to 3 percent from 3.4 percent in December. In January 2010, that rate stood 13.7 percent. By next January, Moody's predicts that the global speculative-grade default rate will decline to 1.5 percent. It expects the default rate will decline to 1.7 percent among U.S. speculative-grade issuers and to 1.1 percent among European speculative-grade issuers. Lower default rates imply lower risk which further implies lower spreads (risk premiums) on corporate bonds. While the market has tightened expecting this outcome, I believe it has further to go and that credit will outperform the risk free and generate positive excess returns.
Bottom line: While risk free debt gets hit globally, risk assets will continue to perform - although not as well as they have. We can see the risk appetite through the EETCs getting done, CMBS, drive by high yield deals and IG credit with virtually no covenant protection.
On the credit note: let these cov lite and no covenant deals get done, do your homework and buy the prior issues with better covenant protection as documents are rarely priced into the market. A little homework can help mitigate risk and lead to outperformance.
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