Corporate Bond Market Holds Up
The market has shown strength in the face of a voluminous amount of new issues and some disappointing economic indicators.
The corporate bond market was modestly weaker this past week as investors continued to digest the deluge of bonds that have been issued over the past few weeks. While the volume of new issues in the corporate bond market slowed from the frenzy of the prior two weeks, it was greater than we had expected for the week before a holiday. There were several multi-billion-dollar deals among the new issues, which continued to pressure credit spreads. Trading has been a bit sloppy as the new issue bonds slosh around trying to find a permanent home, but most market participants appear to be generally comfortable with the level of credit spreads--even in the face of some disappointing economic indicators.
The Morningstar Corporate Bond Index widened 1 basis point last week to +140. One trader mentioned that while the market felt heavy, there was not the wholesale selling of credits that would indicate a change in sentiment towards credit risk. Considering the voluminous amount of new issues the credit market has had to absorb recently, we believe it's a sign of strength that the market has only widened 5 basis points since the beginning of the month. However, if this pace of new issues continues into the summer, we would expect new issue pricing concessions to have to increase, which would pressure credit spreads across the board. At this point, we think much of the new issue calendar has been filled and should abate to normalized levels.
Most of the new issues we have been following continue to trade at levels close to where they were issued. One notable exception was CVS (ticker: CVS, rating: BBB+). Its bonds continued to widen at the beginning of last week, but gained new life Friday. CVS announced that it had been awarded a three-year contract with Blue Cross Blue Shield, which had previously been serviced by Medco Health Solutions (ticker: MHS, rating: A-). We had previously recommended Medco bonds, but had removed Medco in May and replaced them with bonds from Express Scripts (ticker: ESRX, rating: A-). Express Scripts' new five-year bond issue looks attractive to us. At +124, the 2016 notes offered the widest spread opportunity in the pharmacy benefit management sector.
The European financial sector gapped about 18 basis points wider last week as increased scrutiny regarding Greece's ability to support its debt load pushed credit spreads wider among European banks. Greece's 10-year bonds fell to all-time lows midweek as this skepticism has been increasingly reflected in the headlines. Portuguese and Irish 10-year bonds followed suit and also hit new lows.
Not helping matters, the rating agencies continued to put pressure on the sovereign debt market, as Fitch downgraded its rating on Greece a full turn to B+ and S&P put its A+ rating on Italy on negative outlook. In addition, Fitch placed its AA- rating on Japan on negative outlook. Considering that all three agencies have placed Japan on negative outlook since the beginning of this year, it's probably only a matter of time before that country is downgraded to a single A status.
New Issue Commentary
Barrick Gold (ticker: ABX, rating: BBB+) placed $4 billion of bonds, consisting of four tranches: $700 million 1.75% senior notes due 2014, $1.1 billion 2.9% senior notes due 2016, $1.35 billion 4.4% senior notes due 2021, and $850 million 5.7% senior notes due 2041. Proceeds will be used to partially fund the CAD 7.3 billion acquisition of Zambian copper company Equinox Minerals. The three-year and five-year tranches, with corresponding Treasury spreads of 90 and 115 basis points, respectively, were priced right in line with Barrick Gold's existing shorter-dated 2014 and 2016 paper. However, the market price for the new 10-year tranche is wide compared with the existing 2020 issue, which was trading at a spread of 80 basis points before the deal announcement. The new 10-year bond carries a 130-basis-point spread; the 30-year deal offered an additional 20 basis points of spread on top of the 10-year note, which is about 15 basis points wide of the existing 30-year bond. We think both the longer-dated bonds offer better relative values than the existing Barrick debt. Overall, we think the deals are priced fairly compared with the credit quality of the company, particularly when compared with Newmont (ticker: NEM, rating: BBB+), whose 2039 bonds are trading at +133 basis points to Treasuries, and Nucor (ticker: NUE, rating: A-), whose 2037 bond is trading at spread of +98 basis points.
We maintained our credit rating of BBB+ for Barrick Gold after the firm's cash offer for Equinox Minerals, primarily because Barrick had more than $4 billion of cash on the balance sheet at the end of last quarter. Also, after the bull run of the gold prices in the past few years, the firm has accumulated ample ammunition for acquisitions. However, we recognize that Barrick Gold's business risk may increase as a result of returning to Africa to operate. Although Barrick Gold's new bonds are priced fairly in the metals and mining market, we continue to prefer POSCO (ticker: PKX, rating: BBB+), a South Korean steel producer. POSCO has the same rating as Barrick Gold, but its 2020 bond is trading at a spread of +180 basis points, almost 50 basis points wider than Barrick's 10-year deal.
Caterpillar (ticker: CAT, rating: A-) issued $4.5 billion of bonds to help fund its $8.6 billion Bucyrus (BUCY) acquisition. In addition to the new bonds, the company is expected to use commercial paper ($800 million) and cash on hand ($3.3 billion) to round out the financing. Initially, management contemplated raising as much as $2 billion of equity to help finance the acquisition, but instead opted to use cash on hand, given the strong recent performance and positive near-term outlook for the business.
The benchmark financing was split among five tranches. Not surprisingly, the tranches were launched at the tight end of the price talk, with $1.25 billion of 30-year bonds launching at a spread of +98 basis points. Another $1.25 billion of 10-year bonds launched at a spread of +85 basis points. A tranche of $750 million in three-year bonds launched at a +50 basis-point spread, $750 million of two-year floaters launched at a spread of LIBOR plus 17 basis points, and $500 million of 18-month floaters launched at a slightly narrower spread of +10 basis points to LIBOR. The new issue spreads were in line with our expectations and came slightly wide of where Caterpillar's existing bonds were trading.
On the long end, we recently saw the 8.25% notes due 2038 quoted at a spread of +95 basis points and a yield of 5.08%. Also, the 7.90% due 2018 were quoted at a spread of +76 basis points and a yield of 3.37%. We think the new bonds represent fair value relative to the company's existing debt. However, spreads on the company's bonds are about +20 basis points inside the similarly rated bucket of the Morningstar Corporate Bond Index, indicating investors could find better value elsewhere.
We prefer the bonds of Deere (ticker: DE, rating: A), given our one-notch higher rating and the fact that the two names trade roughly on top of each other. Both companies have 2031 maturities that trade at a spread of +122 basis points and a yield of 4.91%. Deere also has a 6.95% note due 2014, which recently was quoted at a spread of +49 basis points, roughly on top of Caterpillar's new three-year bond.
Hewlett-Packard (ticker: HPQ, rating: AA-) pushed through a huge $5 billion debt issuance in five parts, including two- and three-year floating-rate notes and three-, five-, and 10-year fixed-rate notes. The bonds priced at attractive levels relative to the Morningstar Corporate Bond Index and other recent large-cap technology issuances. Though HP lowered fiscal 2011 guidance for the second quarter in a row last week, we believe its core business continues to perform well and that management is taking short-term pain for long-term gain in the important services segment. We also like HP's recent efforts to move into more defensible niches of the IT hardware industry, including its push in networking and storage gear. While HP's new notes have tightened a bit since issuance, we'd be buyers.
HP's 4.30% notes due 2021 were priced to offer +120 basis points over 10-year Treasuries. The typical AA- rated name in the Morningstar Corporate Bond Index, which has a comparable maturity, yields only +75. Last week, Google (ticker: GOOG, rating: AA) was able to issue 10-year paper at +58, which as we mentioned the prior week was too rich (spreads have since widened out to about +70, approaching a reasonable level). Similarly, Texas Instruments (ticker: TXN, rating: A+) issued five-year notes at +60, while HP's 2.65% notes 2016 were issued at +90. We don't believe these gaps are warranted, given our higher credit rating for HP. In addition to HP, we continue to like Cisco (ticker: CSCO, rating: AA) among large-cap tech names. Cisco's 4.45% notes due 2020 recently traded at a spread of about +107 to comparably dated Treasuries.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.