Something at Work in Italian Bond Market
Last week's jump in Italian bond prices did not appear emblematic of a typical market action.
Our skepticism of two weeks ago ("That Can't Be Right") that the latest bailout framework was the solution to stabilize the sovereign debt markets was prescient. Italian bonds cratered in the middle of last week; the 10-year bond fell to new lows Wednesday and the yield blew through 7%. The bonds did quickly reverse those losses before Italy's auction of 12-month bills Thursday. On the short end, 1-year Italian bonds quickly tightened 75 basis points in the few hours leading up to the auction. In fact, bonds quickly rose across the entire yield curve before the auction.
Based on my experience, the jump in bond prices did not appear emblematic of a typical market action. I suspect the European Central Bank was in the market to make sure the bill auction cleared at a yield well inside 7%. After the bill auction, Italian bond prices continued to recover most of their losses from earlier in the week and ended the week nearly unchanged. The 10-year Italian bonds ended Friday at 6.88%, a 510-basis-point spread over German bonds. The market has drawn a line in the sand at 7% for Italian interest rates. Inside 7%, the market believes there is still hope that Italy has enough time to strengthen its economy, get its finances in order, and remain solvent. Over 7%, the market judges that the increase in interest expense would be too great for the country to ever get back to sensible debt metrics, putting Italy on a debt spiral toward insolvency.
Stock markets were emboldened by the recovery of Italian yields and rose enough to end the week slightly higher, with most of the gains occurring Friday. Bond markets were closed Friday for Veterans Day and did not have the chance to participate in the rally. As of last Thursday, credit spreads were 10 basis points wider on the week as the Morningstar Corporate Bond Index rose to +227. It will be instructive to see where the credit markets open on Monday. If credit spreads tighten, we may be in store for a relief rally as the ECB's support encourages investors that the sovereign debt crisis will be mollified until the European Financial Stability Facility is available to backstop Italian debt offerings and bridge the country until its finances heal. However, if credit spreads are unchanged or wider, that will be an indication that the credit markets may not believe the ECB has the wherewithal to support Italian funding until the expanded EFSF is ready--or that even the expanded EFSF will not be able to handle the enormity of Italy's debt requirements over the next two years.
Changing of the Old Guard
Following the approval of economic and regulatory reforms over the weekend, Italian prime minister Silvio Berlusconi resigned, leaving Mario Monti to attempt to form a government. If Monti is unable to form a consensus government, then Italy will have to proceed with general elections, probably early next year. Berlusconi's resignation followed closely on the heels of the resignation of Greek prime minister George Papandreou, leaving Greece to also attempt to form a national unity government.
While Italian bonds recovered much of their losses, the EFSF bonds continued to widen. The EFSF priced a 10-year bond issue last Monday at +177 basis points over German bonds. However, the bonds fell over the course of the week and the spread widened to +188, leading to about a point loss for investors who bought into the new issue. We highlight this loss as investors will become increasingly hesitant to participate in new issues from the EFSF if spreads continue to widen.
It appears that the spread widening among the EFSF bonds is correlated to the decline in France's bonds. French 10-year bonds dropped two and a half points over the course of the week to 99, resulting in a 3.37% yield or a 147-basis-point spread over German bonds. We think the widening for the EFSF is also indicative of the market's unwillingness to invest in the structured vehicle until policymakers restructure the EFSF to expand its lending capacity by leveraging the underlying sovereign guarantees.
Standard & Poor's caused a quick flurry of panic in Europe on Friday when it accidentally sent out a release to a limited number of S&P subscribers that appeared to downgrade France's rating. S&P quickly issued a statement reaffirming its AAA rating on France, but a significant amount of damage to sentiment had already been done. Regardless of issuing a statement to clarify the rating, many investors suspect that the cause of the erroneous release may be due to a review of the country's rating by S&P. As we've highlighted before, if France loses its AAA rating, the EFSF will either lose its AAA rating as well or will have to be downsized by the amount of France's guarantee.
Policymakers continue to work on figuring out a way to expand the lending capacity of the EFSF. No new details were released last week, other than that they intend to announce a plan by the end of November and that the new structure would be ready by mid-December. However, the debt markets can move much more quickly than that timeline, and we wonder if the ECB can continue to support the sovereign debt markets until then.
Jefferson County Bankruptcy Due to Specific Rather Than Systemic Risk
On Nov. 9, Jefferson County, Ala., filed for bankruptcy protection under Chapter 9 of the U.S. Bankruptcy Code prompted by failed negotiations with creditors on $3.14 billion of sewer system debt. According to its bankruptcy petition, the county also has $814 million in limited obligation school construction bonds and $200.5 million in general obligation bonds outstanding.
This action marked the largest municipal bankruptcy filing in U.S. history, topping the 1994 filing of Orange County, Calif., over its debt totaling $1.7 billion. However, the Jefferson County bankruptcy filing should not come as a surprise for investors, nor should it be read as an indicator of increased risk in the broader municipal market. Although municipalities have faced unparalleled stress in recent years, municipal bankruptcy filings remain rare and are expected to remain so. Jefferson County represents an exceptionally low-quality municipal credit that has been plagued by corruption, mismanagement, and unsustainable debt burdens for more than a decade, and the possibility of bankruptcy has been contemplated for the past three years.
In response to a consent decree from the federal government requiring the county to repair and rebuild its sewer system, Jefferson County began issuing significant amount of sewer system debt in 1997. At the time, the estimated cost of the project was $1.5 billion, but costs quickly ballooned to more than $3 billion mainly because of political corruption, malfeasant financial deals, and unanticipated borrowing costs. The county continued to sell sewer revenue bonds over the next several years to fund the project, and by 2004 had issued $2 billion in auction-rate securities and $850 million in variable-rate securities, which were later swapped to fixed rate. In the midst of the financial crisis of 2008 and as liabilities became too burdensome to maintain, the county defaulted on sewer bond payments and failed to meet collateral posting requirements under their swap agreements.
In addition to the troubled finances of the county sewer system, Jefferson County's general operations also faced significant fiscal stress, partially driven by the Alabama Supreme Court decision invalidating the county's occupation tax, which had provided a significant portion of operating revenue. The fiscal picture worsened when lawmakers failed to pass a limited home-rule provision that would have allowed the county to raise replacement revenue. These factors combined to create severe financial stress that ultimately drove the county to declare bankruptcy.
For Jefferson County and its residents, municipal bankruptcy will probably mean higher service costs, higher borrowing costs, and the possibility of limited market access. For bondholders, it remains to be seen what the recovery rates on the county's outstanding debt will be. Historically, recovery rates for essential service systems and general government debt have been relatively high; however, it is possible that some bondholders will not recover 100% of par.
For the municipal market overall, this event (as well as the recent events in Harrisburg, Pa.) will probably reignite some of the debate over the likelihood of systemic risk, most notably voiced by analyst Meredith Whitney on the CBS news program 60 Minutes in December 2010. At Morningstar, we believe that the fate of Jefferson County is due to specific failures rather than systemic, and we reject the notion that this is the first of many dominoes to come. No doubt municipal governments and issuers are faced with historically large fiscal challenges in the current economy, yet that does not imply widespread bankruptcies, in our opinion. What it does mean is that credit analysis has become a very important factor for municipal investors. The idea of credit homogeneity in the municipal market, like many things, has become a fond memory not likely to return anytime soon.
Contributed by Jeff Westergaard, Director of Municipal Analytics, Morningstar.
Headlines on the Horizon
Italy is scheduled to issue five-year bonds today. Italian five-year bonds closed Friday at 6.43% (resulting in a spread of 543 basis points over German bonds). If last week was any indication of the support for the sovereign debt market, we expect that the Italian debt market will be propped up in order to make sure the auction is successful and priced at a rate below 7%. If the deal fails or is priced above 7%, then we recommend that you put on your hard hats and buckle yourself in for another roller coaster ride.
Closer to home, time is rapidly running out for the U.S. deficit super committee, and the political parties will ramp up their posturing in the media to bolster their negotiating positions and set the stage to blame the other side if a deal cannot be reached. Among the economic releases, we'll be watching for any signs of inflation in the PPI and CPI numbers released Tuesday and Wednesday, respectively.
New Issue Commentary
Last week started off strong, as multiple issuers announced new benchmark-size deals. We knew from talking to several debt market syndicate desks that it was going to be a busy week, but we were still surprised by the pace of new transactions. However, the new issue market came to a screeching halt Wednesday, as the decimation of the Italian bond market slammed the new issue window shut. The Italian bond market regained most of its losses Thursday as the country was able to successfully issue new 12-month bills. This act was enough to placate the markets that the country wasn't in imminent danger of insolvency, and the U.S. credit market was able to recover enough for a few more issuers to poke their heads out and price their deals Thursday. We suspect that this week will also be a busy one as issuers will need to come to market before the week of Thanksgiving. Considering how skittish the market is, we'd recommend any issuer that wants to tap the capital markets to do so sooner rather than later. The new issue credit market continues to feel as if it's just one negative headline out of Europe away from closing again.
As a followup to our note the prior week related to buying a new issue from Amerigroup (ticker: AGP, rating: BBB-) and avoiding a new issue from Cigna (ticker: CI, rating: BBB-), Amerigroup priced its new 2019 bonds last week at a significantly wider spread than warranted, in our opinion. The firm issued its eight-year notes at 586 basis points above Treasuries. Comparing that with Cigna, another managed-care firm that we rate BBB-, reveals a significant disparity in yield opportunities for similar risk, in our opinion. Cigna issued 10-year debt the previous week at 205 basis points above Treasuries. We believe investors can obtain more reward for the risk with Amerigroup's notes.
On Monday, Amgen (ticker: AMGN) issued $6 billion in debt to fund its recently expanded share-repurchase program. Given its large cash position and expected cash flows, we didn't expect the firm to need new debt to fund that program. We placed our AA- credit rating under review and will dig into this event more thoroughly, including new reports that Amgen is shopping additional debt in European markets. At first glance, even after incorporating the higher leverage and share-repurchase activity, we probably wouldn't cut our rating more than a couple of notches. Therefore, we'd still take a differentiated view from the agencies, meaning investors may be able to garner a larger spread than warranted on these new notes. At the time of the issuance, we believe firms of this credit quality should trade around 90-125 basis points above Treasuries with a 10-year maturity. Before this announcement, Amgen's 2021 issues regularly traded at the low end of that range, but we've seen them widen out substantially to attractive levels thanks to an agency downgrade. With the new 10-year initially priced at 187.5 basis points above Treasuries, or about double what we'd expect for a firm with this credit quality, we see a buying opportunity for investors. Here are the issuance details:
On Tuesday, AmerisourceBergen (ticker: ABC, rating: A) issued $350 million in 10-year senior unsecured notes. Proceeds of this offering are marked for general corporate purposes, which could be another indicator that corporate issuers are trying to boost their balance sheets before any negative consequences associated with the European debt crisis potentially hit the credit market. The company came to market in line with its existing issue with a maturity near 10 years, pricing at 150 basis points above Treasuries. That price is wider than we'd expect for an A rated industrial firm, which typically trades at an average spread of 120 basis points above Treasuries. We think this new issuance looks attractive. As we've discussed in the past, the agencies appear to display a size bias when rating AmerisourceBergen, which is the third-largest drug distributor in the United States. On average, the agencies rate the firm about two notches lower than we do, and the market typically anchors on those ratings. With $392 million senior notes coming due in 2012, AmerisourceBergen primarily appears to be boosting its balance sheet's flexibility before that maturity. At the end of September, the firm held a $461 million net cash position. We don't think the firm is looking to significantly increase its leverage in the long run, and we are maintaining our differentiated view of its credit profile.
Canadian National Railway (ticker: CNI, rating: A-) issued $700 million of bonds, split between $300 million of 5-year notes at a spread of 75 basis points over Treasuries and $400 million of 10-year notes at a spread of 95 basis points over Treasuries. Proceeds are expected to be used to pay down commercial paper borrowings and for general corporate purposes. Canadian National is the most efficient of the Class I rails with an operating ratio in the low 60s, nearly 10 percentage points better than its peers. As such, the company's bonds tend to trade relatively tight within the sector. Since issuance, spreads on the new notes have remained relatively flat while spreads in the sector have widened 5-10 basis points. At current levels, we maintain our underweight on Canadian National and recommend looking elsewhere in the sector for value. For example, the CSX (ticker: CSX, rating: BBB+) 4.25% due 2021 recently traded at a spread of 145 basis points over Treasuries. Given the relative stability of the sector, we recommend trading down slightly in credit quality and picking up a meaningful spread premium.
Dr Pepper Snapple Group (ticker: DPS, rating: BBB+) issued $500 million of 7- and 10-year bonds. Our BBB+ rating is in line with Moody's, which upgraded its rating in May, and one notch higher than S&P. As we expected, the deal was well oversubscribed as there has been a strong bid in the market for high-quality defensive names. As such, there was no new issue concession. Dr Pepper bonds have been relatively illiquid as they have been put away in long-term hands. The 10-year bonds priced right on top of where we opined the spread would be considered fair value in our new issue note. The 7-year notes priced 5 basis points inside the 10-year and may have room to tighten up to 5 basis points.
Peabody Energy (ticker: BTU, rating: UR-) sold $3.1 billion in 7- and 10-year senior unsecured notes to fund its planned $5 billion acquisition of Australian pulverized coal producer Macarthur. The 7-year bonds priced at 6.00%, a little wider than where we expected, and the 10-year bonds priced at 6.25%, at the wide end of our expectations. At these levels, the market is treating Peabody as far and away the strongest credit in the domestic coal mining industry, a status we think is subject to some debate, given the firm's aggressive growth strategy (low-cost producer Cloud Peak [ticker: CLD, rating: BB+] remains a favorite of ours). Our issuer rating on Peabody (previously BB+) remains under review with negative implications in the wake of the firm's announcement that it would go it alone on Macarthur. Previously, Peabody had intended to partner with ArcelorMittal (ticker: MT, rating: BBB-) on the deal, but it would appear the steel giant got cold feet. As has been the case with most coal merger and acquisition activity over the past year (see Arch's [ticker: ACI, rating: BB-] purchase of ICG and Alpha's [ticker: ANR, rating: BB] purchase of Massey), the acquisition of Macarthur constitutes a bet that metallurgical coal prices will remain elevated for the foreseeable future--a very risky wager, in our view.
For example, Teva's 2021 notes were priced around 170 basis points above Treasuries, or around 50 basis points higher than the average A rated credit. The market appears to have required a pricing concession beyond the agencies' average rating, which is about one notch below our rating. We believe these spreads are attractive for investors. We see these issuances as a way for Teva to refinance various obligations, including $1 billion on an unsecured bridge loan due in December, $1.5 billion in a bridge loan due in March 2012, $1.25 billion in borrowings on two revolving credit agreements due in 2014, and Cephalon's 2.0% convertible notes. We don't anticipate changing our credit rating based on this refinancing.
For reference, the average A- rated firm with a 10-year maturity trades at T+140. The company intends to use the proceeds for general corporate purposes.
Windstream (ticker: WIN, rating: BB+) sold $500 million of 10.5-year notes to repay the remainder of its 8.625% 2016 notes still outstanding and borrowings under its revolving credit facility. The firm recently ratcheted up capital spending expectations for 2011 and 2012, and we expect it firm will generate little cash flow in excess of dividend payments over this period. Windstream carries heavier leverage than management has targeted--3.7 times EBITDA versus a goal of 3.2-3.4 times--and it probably will take well into 2013 to reduce debt meaningfully. Before the new issue, the existing 7.75% 2021 notes offered a yield of 6.90% and a spread of about 525 basis points above Treasuries to their 2019 call date. This spread is wider than we'd expect, given our rating on the firm, and more in line with a mid-BB issuer. However, with the firm still struggling to increase revenue while raising capital spending expectations, we believe this spread is fair.
On Monday, Zimmer (ticker: ZMH, rating: AA) issued $550 million in senior notes, which will be used primarily to repay its recently drawn credit facility. The company drew on that facility to repurchase shares. While not necessarily a friendly activity for debtholders, this increased debt doesn't move the needle on our AA credit rating, as Zimmer still remains modestly leveraged around 1 times EBITDA. Our rating for Zimmer takes a differentiated view from the agencies because of our focus on its wide economic moat in orthopedic devices. Since the market appears to anchor around the agencies' much lower ratings, which we believe display a size bias, we weren't surprised to see Zimmer issue notes at spreads that are much wider than warranted. The firm issued $250 million in debt due in 2014 at a 1.4% coupon, or around T+105, and $300 million in debt due in 2021 with a 3.375% coupon, or around T+140. The average 10-year issue from AA rated firms traded around 85 basis points above Treasuries, so we think investors could be well served by considering Zimmer's notes as long-term investments. Also, compared with key peer Stryker (ticker: SYK), which we also rate at AA, we believe Zimmer's notes could offer a good relative valuation play. Stryker's 2020 issue regularly trades around 115 basis points above Treasuries.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.