Flight to High-Quality Corporate Bonds
It's hard to argue against owning Microsoft bonds at a spread over Treasuries.
Despite the shenanigans in Washington (or more likely because of them), buyers snapped up single A or better paper last week. Investors sought after the highest-rated issuers, such as Wal-Mart (WMT) (rating: AA), Microsoft (MSFT) (rating: AAA), and Johnson & Johnson (JNJ) (rating: AAA). Early in the week, there was market chatter that Chinese investors were out buying the most highly rated bonds, and the speculation was that those accounts were reallocating from other asset classes such as agencies and Treasuries. Insurance companies were also out in force, searching along the entire yield curve for highly rated issuers.
Indicative of this demand, the corporate bond spread for the Morningstar Corporate Bond Index tightened by 5 basis points last week to +154 and the AA rated component was the best-performing rating segment. The long end of the Treasury curve rallied strongly, as both the 10-year and 30-year tightened about 20 basis points to end the week at 2.80% and 4.13%, respectively. Half of the gains came at the beginning of the week, and the other half occurred Friday after the horrible second-quarter gross domestic product number was released.
High-quality corporate bonds are providing a port in the storm, as investors are comfortable owning the debt of issuers that have transparent financial reporting and significant cash reserves on the balance sheet. It's hard to argue against owning Microsoft bonds at a spread over Treasuries. The company has nearly $53 billion of cash and short-term investments on the balance sheet against $12 billion of debt and provides much greater financial transparency than any sovereign issuer. As we posited in the spring of 2010 when the sovereign debt crisis first reared its ugly head, we think the transparency afforded in corporate issuer analysis as opposed to sovereign analysis will allow corporate bonds to outperform sovereign bonds. At that time, we also wrote that we expected U.S. corporate bonds to outperform European corporate bonds because of the lack of full disclosure by the European banks as to their sovereign exposure and the sovereign overhang of the peripheral nations that would lead to selling risk assets.
Even though all the headlines in the United States revolve around politicians trying to score political points as opposed to resolving the debt ceiling, we recommend that investors keep an eye on Europe. One week after the latest Greek bailout was announced, sovereign credit spreads have begun to leak wider. Portugal's 4.80% notes 2020 gave up most of their gains and are trading only a few points above their lows. Ireland's 4.50% notes 2020, which moved up the most, began to lose some of their gains, and Greece's 6.25% notes 2020 began to bleed wider.
More worrisome, the debt and credit default swaps for Spain and Italy continued to widen out. Spain's 4% notes 2020 fell to 87.75, which equates to a 5.82% yield or +347 spread over German Bunds. At this level, these notes are only 2 points higher than before the Greek bailout. Italy's 4.45% notes 2020 fell back to their lows at 89, resulting in a yield of 6.14% or +384 spread over German Bunds. Although we no longer consider sovereign credit default swaps to be the best indicator of credit risk, the swaps for Spain and Italy widened to +350 and +300, respectively. Considering that these nations are much larger than Portugal, Ireland, or Greece, have significantly more debt outstanding, and consist of a greater amount of the eurozone's GDP, if either one is no longer able to fund itself in the public markets, it would be near impossible for the Europeans to craft a bailout.
New Issue Commentary
New issuance was light last week and will continue to be sluggish. Between the tomfoolery among the political parties and the typical August slowdown, we expect the new issue market will remain muted until the beginning of September.
Air Products (APD) issued $350 million of five-year notes last week at a spread of +63 basis points over Treasuries. Proceeds are expected to be used for general corporate purposes, including the repayment of short-term debt (the company reported $430 million of short-term debt as of June 30). The deal was upsized from $300 million and priced at the tight end of price talk. We were not surprised to see the spread widen on the break, with the bonds now trading at a spread in the high 60s, close to where we recently saw the Praxair (PX) (rating: A) 2016 bonds quoted. At roughly the same spread, we still see more value in the Praxair bonds, given our one-notch-higher rating.
Caterpillar Financial Services issued $750 million of five-year notes last week with proceeds expected to be used for general corporate purposes. We recently initiated a credit rating on Cat Finance that is directly linked to that of Caterpillar (CAT) (rating: A-) based on the strong interrelationships between the two entities. The deal was upsized from $500 million and priced at a spread of +62 basis points over Treasuries. Since issuance, the spread on the bonds has widened to closer to 70 basis points over Treasuries, which we think is closer to fair value when compared with John Deere Capital (rating: A). Deere Capital's 2016 bonds recently traded around a spread of +65 basis points over Treasuries, slightly tighter that the Cat Finance bonds, which makes sense to us, given our one-notch-higher rating on Deere Capital.
The day after announcing solid results, Ford Motor Credit issued $1 billion of 10-year 5.875% notes providing a spread of +289. Ford Credit has issued several large offerings over the past year, including the use of FUELs to access the investment-grade market. The new issue was wedged between Ford's earnings announcement Tuesday and the outcome of the debt-ceiling/deficit negotiations in Washington, as companies carefully manage their liquidity. With the high-yield market performing very well this month and new issues meeting strong demand, the offering appears timely. We moved Ford (F) and Ford Credit to our Best Ideas list last month, given our investment-grade rating and expectation for the rating agencies to eventually catch up to us. We view levels in the upper 200s as an attractive entry point relative to potential trading levels upon reaching investment-grade status.
Weekly Fund Flow Data
Morningstar recently enhanced its fund flow data and has begun to disseminate weekly fund flows in addition to the monthly data. For the week ended July 22, we saw a continuation of the theme we have experienced for the past month. Investors have been reducing their exposure to the equity market and are pouring money into the fixed-income market. Money flowing into investment-grade funds beat out international funds this week, though international funds continue to report the greatest inflows year to date.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.