Are EU Periphery Debt Problems Spreading Inward?
Greek bonds are pricing in a near-term default, while French financials are in the hot seat.
Get your game plan for the fireworks ready. The bond market is telling you loud and clear that it expects Greece will default in the near term. Greek one-year bonds have dropped precipitously during the past week, falling approximately 10 points (20 points since the end of July) to about 57 cents on the euro, which is only 10 cents higher than where the 6.25% notes 2020 are trading. At these levels, the bonds are trading toward an assumed recovery value. With the price level between short-dated and long-dated bonds collapsing toward one another, the credit market is rapidly pricing in an increasing probability of default within a year.
Credit spreads among sovereigns and European banks widened out across the board in sympathy. Of particular concern, Italian five-year credit default swaps widened out to new highs early in the week. The decline in the bonds came as the Italian government had been diluting the austerity measures it proposed in August, when the ECB had announced it would purchase Italian bonds in the secondary market and stabilize interest rates. Irish and Portuguese credit spreads also gapped out 50 to 100 basis points (although they are still tighter than their 52-week highs). Italian bonds did recover some of their losses by the end of the week after the government passed additional austerity measures.
The Morningstar Corporate Bond Index widened six basis points last week. However, that was less than the European corporate credit market, which widened out 18 basis points. Credit spread weakening in Europe was primarily driven by the 36 basis-point widening in the financial sector. As we've opined on many occasions, European credit spreads will weaken further and faster than U.S. spreads until a comprehensive resolution addresses the long-term structural problems of the over-indebted peripheral nations and the European banks. Investor fears that Greece is on the precipice of a hard default drove investors to the relative safety of U.S. and German Treasury bonds. The U.S. 10-year declined to an astoundingly low rate of 1.92%, and the German 10-year declined even further, to 1.77%. At these rates of decline, it won't be much longer until U.S. and German Treasury bonds catch up to Japan's 10-year rate of 1.00%.
Ben Bernanke's conference speech last week stopped short of new revelations. It appears to us that the market firmly believes the Fed will conduct additional easing efforts after the two-day September FOMC meeting. Market consensus has centered on "Operation Twist," in which the Fed would sell short-dated Treasury securities in order to purchase long-dated securities. This may be part of the reason that U.S. Treasury bonds have rallied so vigorously, as market participants may be purchasing bonds ahead of the Fed, potentially setting up a "buy the rumor / sell the news" event. Additional easing appears to be so ingrained into market consensus that, if the Fed does not implement any type of new program coming out of the September meeting, look out below.
In other central bank news, ECB executive board member J�rgen Stark resigned. Rumor has it that he resigned in protest of the ECB's recent program of purchasing European sovereign bonds. It's unclear whether this is an indication of Germany's disdain for the bond-buying program, or his own personal views. If the ECB were to discontinue purchasing Italian bonds in the secondary market, the fear is that Italian interest rates would rise to the point where it could no longer finance itself at sustainable rates, and eventually force the country into a debt restructuring. That, in turn, leads to questions of solvency across European banks, and the beginning of a new cycle of contagion across the continent.
Skepticism persists over the credit strength of European banks. As highlighted in mainstream financial media reports, Moody's had placed its credit ratings of several French banks under review for downgrade in June. The rating agencies typically conclude their review for downgrade within 90 days. The review for downgrade is now bumping up against the 90-day timeframe, and the conclusion could be forthcoming shortly. While Moody's reported that the most likely outcome would only be a one-notch downgrade, there exists broader concern that action could pressure France's AAA rating, since the government is assumed to backstop its too-big-to-fail banks. Given that France is one of the largest guarantors of the European Financial Stability Facility, the loss of its AAA rating would have the cascading effect of calling into question the AAA rating of this bailout fund.
Maintaining the perception of solvency by investors and institutions with counterparty risk is paramount to the ongoing funding within the financial system. If the solvency of European banks is called into question, then short-term liquidity can quickly dry up, and lead to a funding crisis. Fortunately, one thing policymakers have learned in the aftermath of the Lehman Brothers bankruptcy is how to deal with, and provide short-term liquidity to, banks when the traditional liquidity channels freeze.
New Issue Commentary
American International Group (AIG) (rating: BBB-) announced on Thursday that it was issuing a new $1.2 billion, three-year fixed benchmark, and a new $800 million, five-year fixed benchmark. The deals priced at +412.5 for the three-year, and +425 for the five-year. While the rating agencies rate AIG in the high-BBB / low-A area, our view is less forgiving. Morningstar's credit rating of BBB- reflects the company's weak core operating brands, somewhat offset by a stabilized balance sheet after the recapitalization from the U.S. government. We rate AIG on its own merits, and assume no further government support. Chartis accounts for about half of AIG's revenue, and is a large, but weak, player in its markets, in our opinion, and has come under fire for under-reserving claims. With AIG's loss of its AAA status and associated dramatic funding advantage, we don't believe the new business model has any real competitive advantage. With spreads of more than 400 basis points, however, we do think investors are compensated in these new offerings. For comparison, we also rate Prudential Financial (PRU) at BBB-, and its spreads are more than 150 basis points tighter at the five-year point. Prudential, like AIG, is a name we rate more harshly than the rating agencies.
Daimler (DDAIF) (rating: BBB+) subsidiary Daimler Finance priced $3.25 billion of new notes Wednesday. The firm priced $800 million of three-year notes at 165 basis points above Treasuries, $1.1 billion of five-year notes at 185 basis points above Treasuries, $750 million of 10-year notes at 195 basis points above Treasuries, and $600 million of two-year floaters at LIBOR+120. Pricing came at the tight end of price talk. Given that we have a similar credit view on Daimler Finance as we do on Daimler, we view the bonds as slightly attractive for our credit rating. We particularly like the five-years at only a 10 basis-point concession to the 10-years.
In looking at comps, we note that Volkswagen's (rating: A-) finance sub U.S. dollar-denominated bonds due 2016 recently were indicated at about 160 basis points above Treasuries, with its 2020 maturities at 175 basis points above Treasuries. We view the Daimler pricing roughly in line with these levels, given our slightly weaker view of the credit. Pricing is also relatively in line with the comparable Morningstar index. Alternatively, Ford Motor Credit (rating: BBB-) has 10-year bonds recently indicated at 386 basis points above Treasuries. We would prefer to move down two notches in credit quality and pick up almost 200 basis points in spread. We expect spread levels on Ford to collapse relative to the other investment grade auto original-equipment manufacturers once it achieves investment-grade ratings by the rating agencies.
We believe the auto OEM space is being negatively impacted by overriding global macroeconomic concerns, even while individual company fundamentals remain strong. Daimler recently reported strong second-quarter results, including record net profit, double-digit earnings per share growth, and high-single-digit top-line sales. Both Mercedes-Benz automobiles and Freightliner trucks continue to perform well, with only its small bus division lagging. Daimler's manufacturing operations continue to maintain a healthy net cash position, and its gross debt/EBITDA ratio is expected to remain below 1.0 during our forecast horizon.
Fluor (FLR) (rating: A) placed a 10-year $500 million unsecured note on Thursday with a coupon rate of 3.375%. The deal ended up pricing at +150, 10 basis points higher than our estimate, which we think gives bondholders a small concession for Fluor's inaugural bond issuance when compared to the new deals Schlumberger (SLB) (rating: A+) and Lockheed Martin (LMT) (rating: A+) placed in the week (we rate both names one notch higher than Fluor), and on par with the Morningstar's A Index option-adjusted spreads of +146 basis points as of Sept. 8. Despite a weak equity market, the new deal traded anywhere between 3-8 basis points tighter in the secondary market on Friday. Fluor has always followed a very conservative financial management policy, and for years maintained negative net debt of more than $2 billion. With the new bond deal, it appears to us that Fluor is taking advantage of the low-yield environment, and possibly replacing its LIBOR-plus short-term liabilities with a low-fixed-rate, long-term debenture. Fluor does not have other bonds aside from a small convertible note, which had around $26 million outstanding as of the end of the June quarter. We like Fluor's conservative financial policy and its prudent financial management, further backed by more than $40 billion of project backlog. However, we anticipate the company will face some near-term industry headwinds related to weak construction activity in developed markets, and ongoing challenges related to raw material costs.
France Telecom (FTE) (rating: BBB+) raised $2 billion Wednesday, split between five-year and 10-year notes at spreads of 195 and 220 basis points above Treasuries, respectively. Comparing the issue to existing France Telecom debt is difficult, given that the firm's U.S. dollar notes are relatively illiquid. The new notes look very attractively priced, however, trading wider than the typical BBB+ rated issuer in the Morningstar Corporate Bond Index (186 basis points above Treasuries). Telecom issues tend to trade tighter than the index. AT&T (T) (rating: A-), for example, offers 130 basis points above Treasuries on five-year notes, and 156 basis points above Treasuries on 10-year notes issued earlier this year, while the Morningstar A- index is at roughly 161 basis points above Treasuries. Verizon Communications (VZ) (rating: A-) is even tighter at 107 and 103 basis points above Treasuries on its five- and 10-year notes, respectively, issued last March.
Looking closer to France, BT Group's (BT) (rating: BBB) 2018 USD notes offer about 215 basis points above Treasuries, versus 223 for the index. The AT&T notes are currently on our investment-grade best-ideas list. France Telecom may have had to offer somewhat wider spreads because of looming price competition in France as upstart Iliad enters the wireless market. We continue to believe this fear is overblown. Iliad lacks the scale to compete in a very mature market, and holds a very limited amount of wireless spectrum. In addition, France Telecom holds a collection of international assets that provide diversification, and should bolster growth. Including the firm's stake in the U.K. wireless joint venture recently formed with Deutsche Telekom (DTEGY) (rating: BBB-), France Telecom's net leverage stands at a reasonable 1.9 times EBITDA. Our biggest fear is that the firm could take on additional leverage to finance an acquisition, likely in an emerging market. However, with management holding a leverage target of 2.0 times EBITDA, we don't expect the firm will radically alter its capital structure in pursuit of a deal.
Despite the turmoil in the European credit markets, Fresenius Medical Care (FMS) (rating: BB+) the world's leading provider of dialysis services and products, was able to price about $955 million in euro-denominated and U.S. dollar-denominated new issues Thursday, up about $100 million from what was planned the day before. Specifically, the firm priced two tranches of senior notes as follows:
As we stated yesterday, we thought a fair coupon for the U.S. notes would have been around 6.25%, given our BB+ rating on the firm, and where Fresenius's other U.S. issues were trading. The firm appears to be giving investors about 25 basis points concession to get the deal done, which we find modestly attractive for investors in this narrow-moat, high-yield issuer.
H.J. Heinz (HNZ) (rating: A-) issued new five-year and 10-year notes. As we have opined in our credit perspective on Heinz, we had expected the firm to tap the capital markets to refinance its significant near-term bond maturities. The size of each tranche was upsized to $300 million and $400 million from the $250 million, and transaction priced at +110 and +125, well inside price talk of +120 and +135 basis points. Considering the firm has $600 million worth of notes due in March 2012, and another $500 million due in July 2013, we opined that we thought the firm would increase the issue size, which may allow the firm the option of tendering for either, or both, of the near-term issues. Considering the bonds were priced inside of talk (which was also tighter than the original whisper numbers) we don't foresee much spread tightening from here, and expect the issue to trade around these levels in the secondary market. As a comparison, Kellogg's (K) (rating: A-) 4% notes 2020 trade at about 115 basis points above Treasuries, and General Mills' (GIS) (rating: A) 5.65% notes 2019 trade at about 120 basis points above Treasuries.
Lockheed Martin (LMT) (rating: A+) priced $2 billion of five-year, 10-year, and 30-year bonds on Monday, with proceeds used to retire a $500 million 2013 maturity, and for general corporate purposes. The firm appears to be opportunistically taking advantage of multidecade low Treasury rates, including sub-2% on the 10-year. Lockheed also recently refinanced its $1.5 billion revolver and extended maturities to 2016. We would note that the firm already has $3.5 billion of cash, and generates substantial free cash flow, and we also recently have seen General Dynamics (GD) (rating: A+) tap the markets and subsequently announce an acquisition. As such, we are suspicious about the use of proceeds beyond the debt retirement, and the likelihood for more shareholder-friendly activities and higher overall leverage. We remain cautious on the defense industry, and believe there is the potential for downside ratings activity as we assess the implications of the recent deficit reduction negotiations. Nonetheless, the bonds appear to have priced slightly wide of where existing Raytheon (RTN) (rating: A) and Northrop Grumman (NOC) (rating: A) similar-maturity bonds were trading, making them attractive owing to Lockheed's higher rating and wide economic moat. The bonds also priced slightly wide of Morningstar's "A" industrials index, suggesting the sector is trading close to fair value.
Praxair (PX) (rating: A) issued $500 million of 10-year notes at a spread of 93 basis points over Treasuries, which seemed a little rich to us. Proceeds are expected to be used to repay debt, fund buybacks, and for general corporate purposes. The deal priced inside initial price talk of 105 basis points over Treasuries, and by our calculation provided no new issue premium, a rarity in the current market. Praxair has an existing 2021 bond that was issued in March of this year at a spread of 67 basis points over Treasuries. Although we hadn't seen it trade much lately, we had seen some small trades in the area of 100 basis points over Treasuries, implying a small new issue premium at the price talk. In the secondary market, the bonds traded at 90 basis points over Treasuries, relatively tight levels compared to comps such as Honeywell International (HON) (rating: A) and Illinois Tool Works (ITW) (rating: AA-), which each have 2021 bonds that recently traded at spreads of 97 and 94 basis points over Treasuries, respectively.
Time Warner Cable (TWC) (rating: BBB-) issued $1 billion of 4.0% 10-year and $1.25 billion of 5.5% 30-year notes Wednesday at 210 and 232 basis points over Treasuries, respectively. At those levels, the new notes will yield roughly 20 basis points more than similar existing TWC notes, indicating a decent new-issue concession, but appropriate for the rating and choppiness in the credit market.
Although the firm listed general corporate purposes as the reason for the issuance, TWC is likely accessing the capital market to fund its planned $3 billion acquisition of Insight Communications. The firm currently carries $3.5 billion in cash, enough to meet nearly all of its current maturities through 2013. In addition, TWC continues to generate solid free cash flow and has completed more than half of the $4 billion share repurchase program announced last year. Despite the share repurchase program, TWC's net leverage has remained below management's target of 3.25 times EBITDA. Even if the Insight acquisition was completed immediately, net leverage would still fall a bit short of the target. We wouldn't be surprised to see TWC add to the share repurchase program later this year.
The new notes look unattractive, in our view, especially the 30-year issue. Given management's often-repeated desire to hold leverage at 3.25 times, our rating is a notch lower than those of the agencies. We'd prefer to see the firm at least let leverage naturally decline from here as EBITDA grows. Closest peer Comcast (CMCSA) (CMCSK) (rating: BBB+), by contrast, targets consolidated leverage at 2.0 to 2.5 times EBITDA, and the cable business, managed separately from recently acquired NBCU, is already down around 2.0 times. Spreads on TWC's 10-year notes have held steady in the secondary market, about 75 basis points wider than similar Comcast notes, which we think is close to reasonable. Though the new TWC 30-year notes have widened about 5 basis points in the secondary market, they still only trade about 35 basis points wider than similar Comcast notes, which we believe is too close. In addition, the TWC notes trade at a significantly tighter spread than the typical BBB- rating in the Morningstar Corporate Bond Index, currently around 300 basis points over Treasuries. For investors able to reach into non-investment-grade territory (per the agencies' ratings), DISH Network DISH (rating: BBB-) is our favorite name. The firm's notes offer spreads in the 500-basis-point range with shorter maturities.
On the backs of Daimler Finance's multi-tranche issue Wednesday, Toyota Motor (TM) (rating: A+) subsidiary Toyota Motor Credit priced $2.5 billion of five-year and 10-year bonds. We view Toyota Credit similarly to Toyota. Toyota Credit issued $1.5 billion of five-year notes at T+125 and $1 billion of 10-year notes at T+145. Note that in January, Toyota Credit issued 5s and 10s at 70 and 80 basis points above Treasuries, respectively. We view the new bonds as moderately attractive, even considering that our rating is weakly positioned in the category, and has downside risk.
In addition to the Daimler Finance and Volkswagen bonds indicated above, Honda Motor (HMC) (rating: A) subsidiary American Honda Finance has 2015 maturities indicated around 115 basis points above Treasuries, and 2020s around 130 basis points above Treasuries. With its well-illustrated problems after the March earthquake, we view Toyota as weakly positioned in the "A+" category with downside ratings risk, and would prefer to get paid at least at "A" levels. As such, we view fair value at levels slightly wide to the indicated Honda levels, closer to 140 basis points above Treasuries for the 10-year, as Honda also has many of the same problems. Honda and Toyota are still working their way back to full production, and have lost market share along the way. Toyota reported a large operating loss for its fiscal 2012 first quarter. We do expect financial results to improve throughout the fiscal year, and were encouraged that fiscal 2012 guidance was dramatically increased from the June guidance. Toyota's manufacturing operations continue to have a strong balance sheet and excellent liquidity, with cash well in excess of debt.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.