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Credit Insights

Credit Markets Steady Amid Other Chaos

Even with mixed economic indicators and volatility in the commodities market, we continue to believe that corporate credit spreads will tighten.

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Investors in the credit markets stepped aside last week and tried to make head or tail out of the extreme volatility in the commodities markets. The turmoil in commodities and foreign exchange was quite a show for those of us not involved in those markets. Over the course of the week, oil declined 14%, agricultural commodities slumped 7%, silver plummeted 27%, copper dropped 5%, and the euro fell 3%. The S&P 500 fell as much as 2.5% intraweek, but regained some ground Friday thanks to the strength in the jobs report and ended the week down 1.7%.

In all this chaos, the credit market was relatively steady as the Morningstar Corporate Bond Index was only off 1 basis point to +136 and credit spreads held their own and digested a relatively full plate of new issues.

Even with some mixed economic indicators earlier last week and volatility in the commodities market, we continue to believe that corporate credit spreads will tighten over the course of the year. Issuers have generally posted strong quarterly earnings and robust credit metrics, fixed-income mutual funds continue to receive a steady stream of inflows as investors demand income, and default rates continue to subside as there is an abundance of liquidity for the riskiest of high-yield credits.

As a testament of the strength in the corporate bond market and investors' willingness to stretch for yield by taking on greater credit risk, the highlight in the credit market last week was the unusual news of a deal for newspaper conglomerate Lee Enterprises (ticker: LEE) that couldn't get done. Considering that even the most highly leveraged buyouts of 2006 and 2007 have been able to refinance and extend maturities at lower rates and payment-in-kind toggle notes have resurfaced, it surprised many market participants to see a failed offering. From our point of view, it's encouraging to see investors push back on a transaction that did not warrant investment regardless of the yield.

Supporting our theme that most of the risk in the credit market this year will come from either merger and acquisition activity or self-inflicted credit deterioration,  ConAgra (ticker: CAH, rating: A-) made an unsolicited bid for  Ralcorp (ticker: RAH, rating: BBB+). ConAgra's $4.9 billion cash bid values Ralcorp at about 7 times EBITDA. If ConAgra is successful with its bid, we think its debt leverage pro forma for the acquisition will place the combined entity on the precipice between investment grade and high yield. Last we saw, ConAgra's 7% senior notes 2019 were trading at +180. On a probability-weighted basis that ConAgra is successful and weighting the potential for ConAgra's rating to slip below investment grade, we think the spread is too tight at these levels and could widen a further 25-50 basis points.

Europe
Similar to the U.S. markets, corporate credit spreads in Europe stepped to the side to wait for more clarity before making a meaningful move in either direction. Although European credit spreads will tighten or widen based on the same fundamentals as the United States, there continues to be a considerable overhang from the ongoing sovereign debt crisis. As we have opined previously, how and when the sovereign crisis works itself out could cause significant short-term volatility for all credit instruments in Europe. If a sovereign debt crisis does erupt in Europe and drags corporate credit spreads wider, we would view that as an opportunity to increase corporate exposure. We are more comfortable investing in corporate bonds relative to sovereigns as the transparency to analyze the underlying fundamentals and credit risk of corporate issuers is vastly greater than that of sovereigns.

After a month of negotiating, Portugal finally finalized its bailout with the European Central Bank and is awaiting the European Union's approval of the plan. The bailout calls for Portugal to reduce its deficit from 9.1% to 3% by 2013. Considering that the yield and credit spread on Spain's bonds has been held to a relatively tight trading range since the beginning of the year, the sovereign credit market is pricing in a high probability that the sovereign contagion has been halted and the line has been drawn in the sand with Portugal. It was almost a year ago that we first said that the eurozone would need to draw the line before Spain and that failure of Greece or Portugal could cause short-term chaos, but that a Spanish default would have dire consequences across the financial system in Europe.

Greek, Portuguese, and Irish bonds, which have been making continuous new lows since the middle of March, appear to have finally found some support.

  • Greece's 6.25% notes 2020 bounced 2 points to 56.75, resulting in a 15.36% yield, which is +1,227 basis points above German bonds.
  • Portugal's 4.80% notes 2020 held steady at 70.25, resulting in a 9.91% yield, which is +680 basis points above Bunds.
  • Ireland's 4.50% notes 2020 moved up more than a point to 69, resulting in a 9.88% yield, which is +683 basis points over Bunds.

There is increasingly more news on a possible restructuring of Greek debt, including an extension of maturities. In fact, midafternoon on Friday, there was a rumor floating around (and quickly refuted by the Greek government) that Greece was threatening to leave the eurozone. While we quickly disregarded this rumor as noise, based on the pace of more reputable news flow, we suspect that the authorities are closer to figuring out how to alleviate Greece's debt problems. However, the news is neither specific enough nor is its pace quick enough to lead us to believe this is a near-term event. Whatever action the authorities end up taking, it will probably become a blueprint for addressing Portugal's and Ireland's balance sheets as well and will provide a guide for how it will affect the European banks and the credit markets. Depending on those outcomes, the blueprint can be adapted to alleviate unwarranted volatility.

If a restructuring of Greece's debt does come to fruition, it appears that an extension of the debt maturities is more likely than a principal haircut. Currently, the 4.60% notes 2013 are trading at 71, resulting in a 23.82% yield. As an example of how a maturity extension may play out, if these notes were extended to 10 years and the coupon was left unchanged, the yield on the bonds would need to drop to 9.05% to break even from current trading levels. Considering that corporate credit spreads have generally been tightening across the board in Europe, including the banking sector, it appears that the European credit market is becoming increasingly comfortable with the idea that the eurozone and its banks would survive restructuring among Greek, Irish, and Portuguese bonds.

 

New Issue Market
 Altria (ticker: MO; rating: BBB) issued $1.5 billion 4.75% senior notes 2021 at +152. Considering that's 7 basis points inside Morningstar's BBB Corporate Bond Index, we don't see much upside from here. However, the issue supports our opinion that  Lorillard's (ticker: LO, rating: BBB) 6.875% senior notes 2020, which currently trade at +230, are cheap on both a relative and absolute basis.

Lorillard has been one of our Best Ideas since August 2010 when the bonds were trading at +360. Now that the risk of an outright ban in the menthol category has subsided, we expect the bonds will continue to tighten toward Altria's trading levels. While a substantial amount of the upside has been priced in, we continue to believe the overall credit risk is similar to Altria and the notes have another 50 basis points left to tighten.

 J.P. Morgan Chase (ticker: JPM; rating: A+) priced $2 billion 4.625% senior notes 2021 at T+148 last Thursday. The original price talk was +150 basis points, but tightened thanks to significant demand. Last we saw, the notes continue to trade near the issue spread, which is appropriate as compared with the previous 10-year benchmark deal that J.P. Morgan priced last October, currently trading in the mid-140s. We remain positive on J.P. Morgan from a credit perspective, as the firm remains well capitalized with a solid balance sheet. For comparison,  Bank of America's (ticker: BAC, rating: A-) 10-year notes trade in the +175 area; we believe the J.P. Morgan notes represent a slightly better value, given our better credit outlook.

 Kansas City Southern (ticker: KSU; rating: BB+) announced the issuance of $200 million of 10-year senior notes at a yield of 6.125% and a spread of +298 basis points. The notes were issued by the company's Mexican subsidiary, Kansas City Southern de Mexico, and the proceeds are expected to be used to tender for two outstanding bonds of KCSM, the 7.675% due 2013 ($32.4 million outstanding; currently callable at 103.813) and the 7.375% due 2014 ($165 million outstanding; callable at 103.668 beginning June 1).  In a note published Friday morning, we wrote that the new notes should price around 6.25% and at that yield, we thought the bonds looked attractive. At 6.125%, the bonds basically priced on top of KCSM's 6.625% notes 2020. Although slightly less attractive to us at that yield, we still think they offer value, given our BB+ rating and favorable near-term outlook for the credit and the sector. The yield also compares favorably with the yield to maturity of 5.97% on the BB bucket of the Merrill Lynch high-yield index. Our rating on Kansas City Southern is two notches higher than that of Moody's and S&P. However, we expect to see sustained improvement in the firm's credit metrics, and any upward rating migration from these agencies could fuel further price gains. As we highlighted in our recent industry piece, we prefer to reach for yield in this sector, given positive fundamentals, and would thus be comfortable trading down in quality and owning these bonds.

In our April 18 article, we said we expected  Republic Services (ticker: RSG; rating: BBB+) to tap the investment-grade market to refinance upcoming debt maturities and calls. The firm wasted no time after reporting solid first-quarter results Thursday to bring a benchmark deal Monday. It priced $1.85 billion in senior unsecured bonds across three tranches: 7-year, 12-year, and 30-year. The maturity schedule along with existing and upcoming calls and maturities will eventually make the new 2018 bond the next maturity, followed by existing maturities in 2019, 2020, and 2021, along with the new 2023 maturity. Several longer-dated bonds mature after that, capped by the new 2041 bond. Proceeds will effectively be used to fund maturities in February, April, and August 2011 totaling about $870 million, as well as the call of a 2016 maturity in May for about another $620 million. Additional tenders are outstanding for bonds due in 2021 and 2035 totaling $450 million, and a $750 million legacy Allied Waste bond due 2017 is callable in June of next year at a premium. The 7-year issue priced at Treasury plus 115 basis points (3.80% coupon), the 12-year priced at T+150 (4.75%) versus the 10-year Treasury (T+138 interpolated spread), and the 30-year priced at T+135 (5.70%). The 7- and 30-year bonds priced largely in line with existing Republic Services bonds and  Waste Management (ticker: WM, rating: BBB+) bonds, while the 12-year priced +15-20 basis points cheap to existing 9- or 10-year bonds, we suspect for technical reasons. We view all of these bonds as solid core holdings on the basis of our view of stable credit quality and the defensive characteristics of the industry.

Click here to see more new bond issuance for the week ended May 6, 2011.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.