Agreeing to Agree to Do Something Really Serious
The EU summit statement lacked any of the details or enforcement mechanisms that we wanted to see.
Credit spreads were almost unchanged on the week as the Morningstar Corporate Bond Index tightened only 1 basis point to +251. The tone of the credit market was cautiously optimistic after the European Union (except for the United Kingdom) announced the agreement among member nations to improve fiscal discipline. The framework would integrate balanced-budget rules into each individual member's constitution with automatic correction mechanisms, provide for automatic consequences upon excessive deficits, and implement new rules to oversee draft budgets and correct excessive deficits.
Investors' enthusiasm was muted, however. They have been through this same situation too many times before. With each prior announcement the markets initially rose, only to decline a short while later as the plan was found to be lacking. The statement made by the EU contained few details other than that the members agreed to agree to create the framework over the next few months, with signing in March 2012. Unfortunately, the statement lacked any of the details or enforcement mechanisms that we wanted. Enforcing fiscal austerity and requiring structural reforms will be the key to the efficacy of this plan over time. However, as we opined last week, at least the politicians are taking the first step--albeit the first down a very long road--to address the underlying cause of the crisis, as opposed to merely addressing the symptoms.
While the new plan lacks any detail, and there will be many bumps along the way, we think improving fiscal discipline will be a positive for the credit markets in general. We have long been skeptical of the plans the EU has put forth, since the prior attempts to solve the crisis merely addressed the symptoms, as opposed to dealing with the underlying cause of the crisis. The prior plans provided liquidity but did nothing to address the solvency of the profligate nations. This plan differs from the previous plans.
At the end of October, in "That Can't Be Right," we found it disconcerting that Italian bonds, which should have been the biggest beneficiary of the bailout, did not appreciate in light of October's "grand plan" announcement. Our concern was well founded, as the rise in Italian bond yields quickly brought the sovereign debt crisis back to the forefront in the beginning of November. Those same bonds did improve slightly after the EU announcement Friday; however, we had expected the bonds to tighten back to the lower yields we saw earlier in the week when the bonds rose substantially on the rumors of increased fiscal union. We'll keep an eye on where Italian bonds are trading, as they have been a strong leading indicator of the sovereign debt crisis and thus a leading indicator of corporate credit spreads as well.
Headlines on the Horizon
The European Financial Stability Facility is reportedly looking to auction EUR 2 billion in bills on Tuesday. By auctioning bills instead of bonds, this auction may be revealing the lack of long-term investor demand for this vehicle. It appears to be a risky strategy for the EFSF, which makes long-term loans, to fund itself in the near term with short-term borrowing and open itself up to rollover risk. Italy and Spain are also reportedly on the docket with bond auctions scheduled for Wednesday and Thursday, respectively. These auctions may help provide better insight into the true investor demand for bonds of these nations irrespective of the intervention of the European Central Bank's secondary market purchase program.
New Issue Commentary
The new issue market was relatively quiet last week. We expect a few issuers may bring deals to market on Monday and Tuesday this week, but the new issue market will thereafter be effectively closed for the rest of the year.
Wells Fargo Plans New Benchmark Five-Year Notes | Dec. 5
Wells Fargo (ticker: WFC, rating: A+) announced Monday that it is issuing new benchmark five-year notes. Price guidance is 175 basis points above Treasuries, which appears to be about 20 basis points cheap to existing notes.
Of the four largest U.S. banks, we are most impressed by Wells from a credit perspective. Wells Fargo has a clear funding cost advantage, as low-cost deposits fund its entire loan book and about 75% of its earnings assets. Its capital position is quite strong with a Tier 1 capital ratio at 11.2% and a Tier 1 common equity ratio at 9.3% as of Sept. 30. The company also has estimated that its Tier 1 common equity ratio under Basel III would have been 7.41% as of Sept. 30.
These notes, however, are priced significantly tighter than J.P. Morgan's (ticker: JPM, rating: A+) current five-year, which trades at about 220 basis points above Treasuries. This tightness is driven in large part by the scarcity of the Wells Fargo name in relation to the J.P. Morgan name. Given the new issue concession provided, and the overall spread level of this A+ name, we think these notes make sense for portfolio mangers who are filled up on the J.P Morgan credit.
Ford Motor Credit Issuing $500 Million Add-On to Its 2021 Maturity Bonds | Dec. 5
Ford Motor Credit (rating: BBB-) is offering a $500 million add-on to its existing 5.875% notes due 2021. We remain overweight on Ford (ticker: F, rating: BBB-) and Ford Credit and continue to recommend their bonds. The 5.875% notes originally were issued in late July at a spread of 289 basis points above Treasuries. Since then, Ford and Ford Credit have been upgraded by all three rating agencies to the high BB area, one notch below Morningstar.
The notes recently were indicated at about 320 basis points above Treasuries, a widening of about 31 basis points. However, during the same period, the Merrill Lynch BB index has widened 171 basis points. As such, with Ford and Ford Credit already trading at weak BBB levels, we recently removed the name from our Best Ideas list. We continue to believe that Ford will navigate the existing global economic uncertainties and benefit from an eventual strong recovery in domestic auto sales, resulting in investment-grade credit ratings. We would note that Daimler's (ticker: DDAIF, rating: BBB+) finance subsidiary has 2021 maturity bonds trading in the area of 185 basis points above Treasuries. We view fair value on Ford Credit at about 100 basis points wide of Daimler, although we expect long-term spread and ratings compression as well.
Hewlett-Packard Looks to Place Its Third Debt Issue of 2011 | Dec. 6
Hewlett-Packard (ticker: HPQ, rating: A) is in the market looking to issue additional debt, its third offering this year. The new notes reportedly will be split among three-year, five-year, and 10-year maturities. Spreads on HP debt widened sharply as the firm's September offering had an especially large new issue concession. Though spreads have since tightened somewhat, HP debt remains attractive relative to the typical A rated credit in the Morningstar Corporate Bond Index. Ten-year notes issued in September at 240 basis points above Treasuries now trade around 210 basis points above Treasuries; the index, excluding financials, is around 137 basis points above Treasuries. The HP notes trade roughly in line with the BBB+ index and S&P's recently reduced rating. We believe HP's existing notes are attractively priced, and we would view any new issue concession as an added bonus.
Though we recently cut our cash flow estimates for Hewlett-Packard, we believe the firm's financial strength continues to warrant an A rating. After funding the Autonomy acquisition, HP ended fiscal 2011 with $8 billion in cash on hand versus about $30 billion in debt. We believe new CEO Meg Whitman's clear strategy of focusing on improving existing businesses and not pursuing expensive acquisitions is a major positive for creditors. While HP faces near-term challenges that will pressure revenue and profitability in fiscal 2012, we believe the firm is positioning itself well for growth in subsequent years. Our renewed confidence in HP's long-term strategy prompted us to recently lower our uncertainty rating on the firm to medium from high.
Gilead Issuing Debt to Fund Pharmasset Acquisition | Dec. 6
We recently cut our credit rating for Gilead Sciences (ticker: GILD) to A from AA- to reflect the firm's risky plans to acquire Pharmasset for $11 billion. This acquisition will wipe out Gilead's current net cash position and require the firm to access about $6 billion in incremental new debt financing. Adding that leverage to the balance sheet will push the firm's debt to about 2 times EBITDA from about 1 times EBITDA currently. On Dec. 6, Gilead announced plans to issue debt to fund that acquisition. It plans to do so in 3-, 5-, 10-, and 30-year increments. Since announcing the deal, Gilead's existing 10-year senior notes have traded around 215-240 basis points wider than Treasuries, which is between the BBB+ and BBB range. That is modestly lower than the agencies ratings of Gilead at Baa1 and A-. If Gilead's new issues are priced at similar levels of its existing issues, we'd consider them attractive, as we believe the average A rated firm should trade around 140 basis points wider than Treasuries. Also, we see upside to our current credit rating. Currently, we do not incorporate any benefits from the Pharmasset acquisition, as all of its potential products remain in development. If its pipeline products succeed, we may consider upgrading Gilead's credit rating.
Viacom Set to Price Bond Deal; We Expect Spreads to Be Attractive | Dec. 7
Viacom (ticker: VIA, rating: A-) plans to issue $750 million in debt in 5- and 10-year tranches. We expect that the proceeds will be used to buy back shares, as the firm raised its share-repurchase authorization last month. With moderate leverage under 2 times, healthy free cash flows of more than $2 billion per year, and a strong Cash Flow Cushion well above 3 times our five-year base-case expense and obligation forecast, this does not concern us. Additionally, we estimate the new debt will bring leverage only to around 2 times from 1.85 times, currently.
With Viacom's current 5- and 10-year bonds trading attractively to our rating, coupled with our expectation of a generous new issue concession, we believe the bonds will offer good value to investors. The firm's 5-year bonds are trading 150-185 basis points above Treasuries and its 10-year bonds are trading just over 200 basis points above Treasuries. This compares favorably with Morningstar's 10-year A- index, which is at 170 basis points above Treasuries. Additionally, Viacom's bonds trade wide to lower-rated Time Warner (ticker: TWX, rating: BBB+), which has 10-year bonds that trade well below 200 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.