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Credit Insights

Contingency Plan Critical for Eventual Greek Default

Given the proper contingency plans, we don't think a default by Greece will cause a widespread financial meltdown.

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While the sovereign debt crisis has been a concern for more than a year, the markets are becoming increasingly focused on the day-to-day headlines concerning Greece. The first Greek bailout was insufficient to tide the country over to the point that it can access the public markets, and now an additional bailout financing is being negotiated.

While it appears that the eurozone members and the European Central Bank will continue to support Greece in the short run, the country's eventual default will be a surprise to no one, as the bond market is already pricing in a likely default within the next two years. Greece's yield curve is inverted, the 5-year credit default swaps are trading well over +2000, and the 10-year bonds are trading around 54 cents on the dollar. The real test will be whether the ECB has developed contingency plans to mitigate any liquidity issues that may arise from the Greek default and stem any contagion before it starts.

We don't think a default by Greece will cause a widespread financial meltdown. While many Greek banks hold a significant amount of sovereign Greek debt as a percentage of their capital and would probably fail, it appears that most European banks' exposure is manageable. Reportedly, only seven European banks have exposure to Greek debt that is more than 10% of their equity. In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor, manage, and hedge their credit counterparty risk. Thanks to the credit crisis, bankers and bureaucrats have learned how to keep liquidity from drying up by providing a combination of backstops, guarantees, and liquidity. A Greek default with appropriate measures in place to keep the markets functioning would assuage fears that contagion with Portugal and Ireland would bring the financial system to its knees.

However, while we think it is likely that the ECB has been developing a contingency plan, a default by Greece without such a plan to provide liquidity to the financial system could cause a liquidity crisis that would reverberate throughout Europe and take its toll on the struggling recovery. In this scenario, sovereign credit spreads would widen and drag both international and domestic corporate credit spreads wider as well.

In either scenario, our takeaway is that sovereign credit quality in Europe continues to decline. The European peripheral nations have not begun to dig themselves out of their hole yet and the strongest nations--those funding the bailouts--are weakening their credit profiles by taking on additional debt and guarantees. Considering the complexity of the different sovereign bailout funding mechanisms, the off-balance-sheet nature of entitlement obligations, and the time lag in reporting economic metrics, fixed-income investors are becoming increasingly weary of the inherent risks in investing in sovereign credit as opposed to corporate credit. This supports our longstanding thesis that corporate credit provides investors superior transparency relative to sovereign credit and should lead to better risk-adjusted returns over time.

Possible Moody's Downgrade of Italian Banks Adds to Market Pressure
Late Thursday, Moody's placed 16 Italian banks on review for possible downgrade. The move was based on Moody's June 17 announcement that it was placing the Republic of Italy's bond rating on review for possible downgrade as a result of slowing economic growth and the overall risks faced by European countries with large debt balances. A downgrade of this rating would call into question the Republic of Italy's ability to support Italian banks and diminishes the overall balance sheets of Italian banks, since a large portion of their holdings is in the sovereign debt of Italy. Trading in Italian bank stocks was halted Friday as Intesa Sanpaolo and UniCredit fell more than 7% intraday.

While we acknowledge the serious issues facing Italy and its banks, we think some of the reaction may have been overdone. No investor in Italian banks should have been surprised by a possible downgrade, since the Italian government's high debt/GDP ratio has been known for some time. Ultimately, any investment in Italian banks is a macroeconomic bet on the future of the Italian government, and with a debt/GDP ratio of more than 115%, buyer beware.

 

New Issue Commentary
 Danaher (ticker: DHR; rating: A-) issued $1.8 billion of bonds to help fund its $6.8 billion acquisition of  Beckman Coulter (ticker: BEC). During the prior week, the company received approval from the European Commission, which was seen as the last applicable regulatory hurdle to the proposed transaction. In addition to the new bonds, the company is expected to use commercial paper ($1.65 billion), cash on hand ($2.3 billion), and equity ($965 million) to round out the financing.

The benchmark financing is split among four tranches and was launched at the tight end of the price talk, with $300 million of 24-month floaters launched at a spread of LIBOR + 25, $400 million of 3-year bonds launched at a spread of +65, $500 million of 5-year bonds launched at a spread of +80, and $600 million of 10-year bonds launched at a spread of +95. The new issue spreads were broadly in line with our expectations, but represent value relative to other A rated diversified industrial credits, in our view. For example, credits such as  Honeywell (ticker: HON, rating: A) and  Dover (ticker: DOV, rating: A+) each have recently issued 10-year bonds that trade at spreads in the mid- to high +70s. We think the incremental spread offered on the Danaher bonds looks attractive, but also implies that the market views the credit more in line with the Morningstar rating as opposed to the NRSRO ratings, which are one or two notches higher than ours.

 J.P. Morgan Chase (ticker: JPM; rating: A+) priced a new five-year benchmark consisting of $2.5 billion 3.15% senior notes 2016 at +165. We think the new note issue is cheap compared with where the existing five-year bonds trade, which is in the +150 range. We remain positive on J.P. Morgan from a credit perspective, as the firm is well capitalized with a solid balance sheet. As investors begin to look to the financial sector to pick up yield for rating, JPM is a top choice. Investors with a little more risk appetite can look to names such as  Citigroup (ticker: C, rating: A-), where they can pick up more than 50 basis points of spread over J.P. Morgan for a lower rating of just two notches.

 Insulet (ticker: PODD) issued $125 million convertible debt due in 2016. The proceeds may be used to repurchase existing debt securities in 2013. This new issuance takes some pressure off Insulet to repay debtholders in the near term, which could cause us to modestly raise our CCC credit rating. We are placing our credit rating under review to reassess the risks. However, we'd still remain cautious about the firm's financial prospects.  Medtronic (ticker: MDT, rating: AA) is planning to launch a competitive tubeless insulin pump in 2012. Since Medtronic controls about 80% of the insulin pump market, we remain concerned that Insulet will have trouble competing for customers once Medtronic enters the picture. The high uncertainty around Insulet's long-term competitive environment makes us cautious about its financial prospects. We currently believe Insulet shares are overvalued, so we probably wouldn't find the convertible debt issuance attractive from an equity sensitivity standpoint. Also, given the long-term risks surrounding Insulet, we'd probably need equitylike returns from its yield to get interested in the issue from a credit sensitivity perspective.

 NuVasive (ticker: NUVA; rating: BBB-) issued $350 million in new convertible notes due 2017. At first glance, we don't anticipate changing our BBB- credit rating because of this new issuance, as most of the proceeds will go toward repaying the firm's 2013 convertible debt issue. We think NuVasive shares are about fairly valued, so we probably won't view them as attractive from an equity sensitivity standpoint either. We'll keep an eye on a potential credit-sensitive play. We've seen 10-year issues of BBB- firms trade around +225. With a 6-year expected term, we probably need to see NuVasive's implied spreads indicated around that 10-year BBB- benchmark or cheaper for them to be deemed attractive from a spread perspective.

Click here to see more new bond issuance for the week ended June 24, 2011.

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