Bangkok--15 Nov--Standard & Poor's
Market volatility continues to look low, according to a report released today by Standard & Poor's Ratings Services. With speculative grade spreads tightening by 21 basis points (bps) since the end of September to 356 bps, risk aversion seems like a non-issue, suggesting a fair amount of investor risk tolerance and complacency. The report, titled "Outlook For U.S. Corporate Bonds: Risky Reward," states that credit markets quickly absorbed the surprise from the October employment report, which showed the unemployment rate slipping by 0.2% to 4.4%, the lowest since March 2001. Hopes for a near-term cut in the fed funds rate have receded and the market has realigned itself to Standard & Poor's long-held view that the Fed should remain on the sidelines with a 5.25% fed funds target through mid-2007. "Corporate bond risks remain skewed to the upside, particularly as the liquidity cycle, the business cycle and profit cycle start moving in sync in the year ahead," explained Diane Vazza, Managing Director and head of Standard & Poor's Global Fixed Income Research.
Simultaneously, the credit cycle's many facets—the downgrade cycle, the default cycle, and the cost and availability of funds—are about to navigate more testy waters. Thus, credit quality is likely to gradually deteriorate from its current strong level. The low volatility environment implies that the market is susceptible to sudden reversals, particularly if event risk picks up.
Risk takers have received better rewards this year. High yield bond returns through October looked impressive at 8.81%, with high-grade bonds trailing at 3.85%. With the 10-year Treasury yield expected to reach 5.2% by mid-2007 and 5.4% by year-end, the risk-reward tradeoff is likely to deteriorate.
Low risk aversion seems to be rooted in stable policy expectations, both on the Fed and fiscal fronts. Long and variable lags for monetary policy imply that past Fed tightening has yet to fully affect the economy and credit markets. The high yield market is expected to be at the frontier of the needed adjustment, which has failed to emerge thus far in 2006. Credit metrics should slowly turn around as the liquidity and credit cycle dynamics mesh more strongly in the year ahead. To clarify, as interest rates normalize and profit gains slow, risk aversion and spreads should increase.
Credit metrics present a stable profile, with the run rate for 2006 downgrades and upgrades matching the 2005 experience. While the speculative grade default rate fell to a record low of 1.27% in October, other leading credit quality measures continue to raise cautionary flags; for example, 26% of issuers have a negative outlook or CreditWatch status versus 24% in January. The speculative grade default rate is expected to climb toward 3.0% by late 2007.
Strong corporate bond issuance for 2006 of $759 billion is handily beating the 2005 figure by 28%. While strong supply has been quickly absorbed by financial markets this year, the low payoff from taking increased risk is likely to hold back investor interest, particularly as the economy slows toward a 2.3% growth pace in 2007.
The report is available to subscribers of RatingsDirect, the real-time Web-based source for Standard & Poor's credit ratings, research, and risk analysis, at www.ratingsdirect.com . If you are not a RatingsDirect subscriber, you may purchase a copy of the report by calling (1) 212-438-9823 or sending an e-mail to [email protected] . The report is also available at www.sandp.com/gfir , listed under Global Fixed Income Research. If you have not previously registered with the site, you will need to do so to access this material. Registration requires minimal information and is free. Members of the media may request a copy of this report by contacting the media representative name provided.
Media Contact:
Mimi Barker, New York (1) 212-438-5054, [email protected]
Analyst Contacts:
Diane Vazza, New York (1) 212-438-2760
Standard & Poor's, a division of The McGraw-Hill Companies (NYSE:MHP), is the world's foremost provider of financial market intelligence, including independent credit ratings, indices, risk evaluation, investment research and data. With approximately 7,500 employees, including wholly owned affiliates, located in 21 countries. Standard & Poor's is an essential part of the world's financial infrastructure and has played a leading role for more than 140 years in providing investors with the independent benchmarks they need to feel more confident about their investment and financial decisions. For more information, visit http://www.standardandpoors.com .
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