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Credit Insights

Troubles Continue for European Banks

The markets continue to price in a high probability of default as European regulators debate rather than compromise on a solution.

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European banks can't seem to catch a break. As if the threat of a Greek restructuring weren't enough, the  UBS (UBS)  rogue trader incident has investors again facing the reality that these institutions are simply tough to manage.

However, regulators finally did something somewhat constructive last week. Faced with rumor and speculation that European banks are having difficulty borrowing U.S. dollars, the European Central Bank, in conjunction with the Fed and a host of other central banks, announced plans to expand the availability of short-term dollar funding through a coordinated lending facility. The announcement helped foster a rebound in credit spreads across the board, with European financials ending relatively unchanged versus a week ago.

Despite the actions of the ECB and the relative calm in the markets late in the week, problems in Europe continue to boil. While the prices of Greek bonds stopped dropping, they haven't increased, either. With one-year bonds still trading below 60 cents on the euro, the markets continue to price in a high probability of default as European regulators debate rather than compromise on a solution. Against this backdrop and in preparation to launch credit ratings on European banks, we've reviewed exposures to the sovereign debt of Portugal, Italy, Ireland, Greece, and Spain.

The following chart shows European banks exposure as a percentage of core Tier 1 capital, drawing data from filings, company presentations, and the released results of the European bank stress tests.

As the chart shows, banks tend to hold large balances of the debt of their home country. For example, Italian-based Intesa holds more than 150% of its core Tier 1 capital in Italian government debt. For banks like Intesa, large write-downs of their government debt would have disastrous results for their capital positions and would most likely require some type of recapitalization. Some banks, like Dexia, ended up with PIIGS exposure even though they were not based in these countries, a result of their business models and the search for higher-yielding assets.

There are numerous outcomes for how the European sovereign debt situation will be resolved, from a disastrous contagious default and dissolution of the euro to a more benign support scenario where the ECB can allow the governments to muddle through their problems. It appears that each week, and sometimes each day, the market oscillates between one extreme and the other as to which scenario is the most likely.

Morningstar plans to release its European bank credit ratings at the end of September or early October.


New Issue Commentary
On Tuesday,  Stryker (ticker: SYK, rating: AA) announced plans to issue $750 million in senior unsecured notes due in 2016. Stryker remains one of the most fiscally sound firms that we cover, and we're somewhat surprised by this issuance. At the end of June, the company was sitting on $2.7 billion in cash and investments compared with only $1 billion in debt. Since it really doesn't need cash at this time, we assume the firm is acting opportunistically to take advantage of extremely low interest rates. While its existing notes don't trade very often, the average AA rated industrial firm in our coverage universe trades at about T+95 at a 10-year maturity. Considering that our rating is two to four notches higher than the agency ratings, we weren't surprised to see the bonds priced wider than we'd expect for a typical AA rated firm. The notes were offered with a coupon of 2.00%, or T+110, which we find modestly attractive for investors. This issuance also provides Stryker with a very low source of funding for a variety of corporate activities, including acquisitions and share repurchases.

Stryker remains active on the acquisition front, primarily making small, tuck-in acquisitions such as the recently announced $135 million Concentric Medical purchase, which will expand its neurovascular product offerings. However, rumors hint that the firm might be interested in  Smith & Nephew (ticker: SNN), another big player in orthopedic implants, with a market capitalization that exceeds $8 billion. At this point, a merger that large would surprise us for a variety of reasons (antitrust issues, Stryker's own diversification strategy, and Smith & Nephew's new management team), but investors should be aware of the possibility. From a capital allocation standpoint, repurchasing shares might be a good use of funds due to what we see as the steep discount at which Stryker shares are trading relative to their intrinsic value. Given its extremely strong balance sheet and high expected cash flows, we wouldn't change our credit rating even if Stryker were to use all of the proceeds from this new debt issuance to fund share repurchases.

 Hewlett-Packard (ticker: HPQ, rating: A) issued $4.6 billion of new notes split among five issues, with fixed-rate notes in 3.5-, 5-, 10-, and 30-year maturities. The notes priced at T+200 for the 3.5-year notes through T+270 for the 30-years, which we believe is very attractive, especially for our rating. HP's 10-year notes issued earlier this year were trading around +135 the day before the offering, indicating an especially large new issue concession on the new 10-year issue (T+240).

While spreads on HP debt look attractive, the firm faces significant uncertainty. We lowered our credit rating recently given that the firm's acquisition strategy is still unfolding and its balance sheet has taken a hit as a result of heavy share-repurchase activity. Current market conditions are also less than ideal, especially since HP had telegraphed the need to issue additional debt to finance its planned acquisition of Autonomy, the British software maker. These factors have kept us from adding HP to our Best Ideas list. With new debt in the market and spreads wider as a result, we may look to add the firm in the near future. Given the particularly large concession on these notes, the firm's large cash balance, and its strong current competitive position, we'd focus especially on HP's shorter-dated issues. In our view, management is unlikely to do anything that severely hampers the firm's near-term credit quality, but the longer term is still open to debate.

 PNC Financial Services Group (ticker: PNC, rating A-) issued $1.25 billion of new 5-year notes. PNC's existing 5-year had been trading around the +180 area to the curve, although we have heard that this note traded much tighter than that the morning of the new debt offering. The best comparable is  BBT (ticker: BBT, rating: A-), whose 5-year note has also recently traded in the +180 area to the curve. The PNC notes were issued at +185, which represents decent value, in our view. All bank credit spreads have widened dramatically in recent weeks, mostly because of the problems out of Europe. PNC is a large regional player in the United States with outstanding capital levels and virtually no exposure to Europe. Its conservative approach to banking allowed PNC to avoid many of the problems its competitors experienced during the financial crisis, and we expect that conservative approach to continue.

 Intel (ticker: INTC, rating: AA) raised $5 billion of new debt split among 5-, 10-, and 30-year notes, adding straight debt to a balance sheet that previously only included a handful of smaller convertible issues. Our wide moat rating on Intel informs our strong credit view of the firm relative to the major rating agencies. We believe that Intel's position in the microprocessor market is virtually unassailable at this point, and that its position in the broader semiconductor industry will enable it to navigate the maturation of the PC market. Intel's balance sheet is pristine--more than $13 billion in cash and investments against $2.2 billion in debt at the end of the second quarter. Even with the new debt issuance, the proceeds of which will largely be used to fund share repurchases, the balance sheet will remain in excellent shape, since the firm has generated more than $20 billion in EBITDA and $8.5 billion of free cash flow over the past year.

Looking at other large-cap tech companies with similar ratings and where we are similarly more favorable than the agencies--such as  Cisco (ticker: CSCO, rating: AA),  Oracle (ticker: ORCL, rating: AA),  IBM (ticker: IBM, rating: AA-), and  Applied Materials (ticker: AMAT, rating: AA-)--we had expected the 5-year notes to eventually trade around 100-110 basis points over Treasuries, with spreads on the 10-year notes around 25 basis points wider than that. Actual issuance came right in line with this expectation: The 5-years priced at T+110 and the 10-years at T+135. While these levels leave the bonds in line with Intel's peers, Cisco in particular, we believe the new bonds make attractive holdings.

 Sealed Air (ticker: SEE, rating: BB) announced plans Thursday to issue $1.5 billion in senior unsecured notes due 2019 and 2021 under Rule 144A, with proceeds to fund the planned acquisition of Diversey and repay existing Diversey debt. Judging by prevailing levels on Sealed Air's existing unsecured notes and a scan of spreads on comparable BB names, we'd expect to see the new issues to price in the neighborhood of 560 basis points above Treasuries, plus a rather fat new issue concession. Based on disclosures from Sealed Air earlier this week, which offered additional clarity on the Diversey financing package, the new issues would rank junior in the postdeal capital structure to a new $1.1 billion term loan A and $1.2 billion term loan B. Total secured debt would account for $2.3 billion of the $5.2 billion in pro forma debt. As such, we'd expect the new unsecured bonds to trade a bit wider than a generic BB name with a capital structure wholly composed of pari passu issues.

 Bank of New York Mellon (ticker: BK, rating: A) announced Friday that it will issue a new 10-year benchmark note. Bank of New York's current 10-year is priced about 135 basis points above the curve. This new deal would appear to have about 15 basis points of new issue concession, which could be a little wide from where recent deals have priced, so we expect it could be priced tighter. Overall, we are very positive on the name from a credit standpoint, as its strong Tier 1 capital ratio and leading market position in the global custody business make Bank of New York hard to beat. However, because of their scarcity, Bank of New York bonds trade with very tight spreads compared with other financials. For example,  J.P. Morgan's (ticker: JPM, rating: A+) 10-year trades about 50 basis points wider than where this new issue could be priced. Investors who are filled up on J.P Morgan credit will have to pay a fairly significant premium to diversify their portfolios into more of the hard-to-find Bank of New York credit.

Click here to see more new bond issuance for the week ended Sept. 16, 2011.

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