Global Credit Markets Recover, But Risks Remain

The 2008—2009 finance meltdown had a dramatic impact on global credit markets. Liquidity dried up, and risk-averse investors flocked to high-quality government bonds.

Central banks and governments took extraordinary steps to support credit markets in order to improve liquidity and stimulate weakened economies. Central banks cut their target interest rates to historically low levels—close to zero in some cases—and have yet to raise them. They began purchasing government, agency, and mortgage-backed securities to support the markets and provide financial institutions with liquidity.

Governments enacted stimulus programs to jump-start economic growth. In the U.S., the Federal Reserve added $1.5 trillion in purchased securities to its balance sheet. As a result, the money supply expanded dramatically. For the most part, it seems those efforts have been successful. Since March 2009, global credit markets have staged a sharp recovery and are returning to near-normal conditions. Investors have renewed their appetite for risk, but they remain wary.

Governments will be borrowing heavily in order to refinance existing debt and cover the costs of their stimulus programs. As a result, bond markets are likely to come under pressure in 2010, particularly if the economic recovery gains traction.

If growth accelerates, central banks will likely raise their target interest rates in order to head off inflationary pressures. Rising interest rates will have the following consequences:

• Government bonds: Yields on U.S. Treasuries and overseas government bonds have risen sharply off their lows in late 2008 because fears of deflation have abated. Yields are likely to rise further, encouraging investors to absorb increased supply. "The question is what level of yields will be required to handle the expected supply," says Mary J. Miller, Director of T. Rowe Price Fixed Income. “We don’t know the answer.”
• Corporates: Despite a rally in the first half of 2009, the difference in yield (spread) between corporate issues and Treasuries and European government issues of the same maturity have dropped between 200 and 250 basis points (100 basis points equal 1%). The 10-year historical spread averages about 172 basis points in the U.S. and 105 basis points in Europe, suggesting corporates remain attractive and investors are being paid to take risk.
• Securitized credit: Government-supported issues, such as residential mortgage securities, have seen a more substantial narrowing in spreads. Spreads on securitized credit card and prime auto loans have also returned to pre-crisis levels. Among bonds that are not government supported, such as subprime consumer asset-backed issues, the spreads remain wide. Although the immediate outlook for commercial mortgage backed securities (CMBS) is pessimistic, our analysis suggests that the highest-quality CMBS tranches should likely avoid defaults.

When the credit crisis occurred, emerging markets were in relatively strong financial shape. Their condition has eroded because the worldwide recession has cut demand for commodities and investors have fled riskier sectors, including emerging markets.

Michael Conelius, manager of the T. Rowe Price Emerging Markets Bond Fund, believes emerging markets have been well positioned to weather this crisis. Flexible exchange rates, rather than real economies, have absorbed much of the shock. The International Monetary Fund (IMF) has increased its lending capacity and relaxed loan criteria, helping countries avoid default. With little inflationary pressure in the global economy, emerging market central banks aggressively have cut interest rates, helping stave off recession in many cases.

These measures helped investors regain their appetite for risk, leading in turn to a recovery in emerging market bonds. Conelius believes the outlook for the emerging markets is generally good because most emerging markets have fiscal and trade surpluses. As a result, they have been redeeming bonds rather than issuing them.

In addition, a number of markets are well positioned to take advantage of the global recovery. Given its large exposure to commodities, Brazil could be a particularly early beneficiary. Asian markets' refinancing needs are relatively stable and will not be burdensome. Only emerging Europe is facing refinancing problems. Western banks may have to slash their exposure to the region, which could trigger further economic deterioration and increased defaults.

Aside from the supply pressures in government bond markets, there are a number of short-term risks that could slow the recovery in credit markets:

• Ratings downgrades: As rating agencies catch up with the deterioration in credit quality, the current wave of downgrades could extend into 2010. Downgrades create potential valuation problems and could lead to forced selling.
• Second market liquidity: The corporate debt inventory held by U.S. primary dealers shrank considerably in 2008 and only recently has shown signs of stabilizing. The crisis left behind a smaller universe of brokers with less capital to support their trading desks.
• Bank write-offs: The IMF estimates that by the end of 2010 global bank write-offs will total $4 trillion, which is $2.5 trillion more than the losses already recognized. If the economic recovery is weak and bank write-offs mount, the outlook for financial issuers will be dire.

Despite improving global credit markets, investors remain cautious. The lingering risk aversion, which boosts demand for government bonds, should alleviate some of the supply pressures from large amounts of government debt. As economic and credit market conditions improve, renewed appetite for risk should reduce credit spreads.

Spreads for investment-grade corporate issues remain above their historic levels and continue to be attractive. Securitized issues, particularly credit card, student, auto, and home equity loans, are more problematic. These markets are currently functioning because of government support; when the government withdraws, it is unclear what conditions will prevail. In order to reduce risk, investing in these issues will require detailed credit analysis of the underlying issues.

In emerging markets, economic fundamentals appear to have held up despite the developed world's economic slowdown. Expanded IMF lending authority should provide a cushion for emerging markets as they deal with the next few years of slower growth.