Greek Stand-Off in the Credit Market
For spreads to tighten, the market must have definitive documentation on the next installment of Greece's bailout and a debt exchange agreement from Greek bondholders.
Credit markets appeared on hold last week, awaiting the terms and conditions of a Greek bailout (which was finally hammered out early this week). Accordingly, bonds ended the week roughly flat and didn't move much throughout the week.
The Morningstar Corporate Bond Index remained at around 200 basis points over Treasuries. The credit market is clearly more cautious than the equity market, as bailout chatter whipsawed stocks during the week, despite generally positive domestic economic indicators. On news Friday that a Greek bailout appeared more likely, the Dow and S&P 500 ended the week up more than 1% after being flat to down Tuesday and Wednesday, when the markets reported a snag in negotiations.
Equity markets favored global news over U.S. headlines, which included data that, for the most part, met or exceeded expectations. If there was a miss, it could easily be explained away. Retail sales, excluding weak auto sales, matched consensus at 0.7%. Auto sales were soft as dealers cleared inventory at lower prices, but a spending pullback in big-ticket items such as cars indicates to us that consumers have a dash of caution in their optimistic outlook of the economic road ahead. Flat industrial production missed consensus by 70 basis points, but softness in mining and utilities was to blame. Warmer weather was the primary factor pushing down the utilities component, which wasn't a surprise. Home construction increased 10% year over year with housing starts at 699,000, beating consensus by 24,000. Initial jobless claims were at the lowest level since early 2008 at 348,000 (versus consensus of 365,000). The rise in the Consumer Price Index met expectations at 0.2%.
By the end of the week, positive news hit the tape indicating that Germany was no longer going to require just a partial bailout aimed at encouraging Greeks to implement necessary wage, government spending, and pension cuts. In addition, the European Central Bank will not be forced to take a loss on its EUR 50 billion in Greek debt--earlier a key hindrance to an agreement. The ECB will get an exception to the newly proposed clause that will force all bondholders to exchange their Greek debt once there is a majority agreeing to the swap.
Even with Germany loosening its requirements and the ECB-friendly clause--which we view as steps in the right direction--the credit markets didn't move. This lack of movement didn't surprise us, as we contend that for spreads to tighten, the market must have definitive documentation on the next installment of Greece's bailout and a debt exchange agreement from Greek bondholders. We argue that while it was necessary to the credibility of the ECB that it not take a loss on its Greek bonds, such an exception is not likely to make the other Greek bondholders happy about signing an exchange deal.
New Bond Issuance
We Expect Teck's New Bonds to Price Richly; Greatly Prefer Southern Copper's Notes (Feb. 16)
Diversified miner Teck Resources (ticker: TCK, rating: BBB) announced Thursday that it is coming to market with a new senior unsecured note offering. Teck expects to apply the proceeds to redeeming high-coupon debt issued in May 2009 (including $530 million of 9.75% notes due 2014 and $1.04 billion of 10.75% notes due 2019), which was a less-than-ideal time for a miner to issue debt, but a move the company had to undertake to shore up its liquidity and capital profile at the time.
Teck is expected to issue 7- and 30-year notes. In the event the new bonds price in line with prevailing levels for the company's outstanding bonds of comparable maturity, we would expect the 7-year notes to price 150-160 basis points above Treasuries and the 30-years at 200-210 basis points above Treasuries. From our perspective, that would be very rich relative to both our BBB rating on the firm (the average nonfinancial BBB in the Morningstar index trades at 222 basis points above Treasuries with an average term around 10 years) and comparable issuers in the mining industry. We'd greatly prefer owning the bonds of low-cost copper producer Southern Copper (ticker: SCCO, rating: BBB+). Not only do we view Southern Copper as a stronger credit at BBB+, but also its comparably dated bonds trade well wide of Teck's. Southern Copper's 5.375% notes due 2020 currently trade in the neighborhood of 225 basis points above Treasuries, and the long-dated 6.75% notes due 2040 offer a spread of roughly 320 basis points above Treasuries.
We Prefer Juniper or HP Debt Over Corning's New 30-Year Offering (Feb. 15)
Corning (ticker: GLW, rating: A-) plans to issue $500 million of new 30-year debt, keeping with its generally long maturity profile--more than half of the firm's $2.4 billion existing debt load comes due after 2028. Corning's long debt maturity schedule and large cash balance enable it to score very well on our Cash Flow Cushion measure. This measure plays a large role in our rating on the firm.
However, when considering a long-term bond such as the new 30-year offering, we prefer to place more emphasis on our economic moat rating. We believe Corning has carved out a decent competitive advantage in the display glass business on the basis of scale and its manufacturing capabilities in a highly consolidated industry. However, we also believe Corning's advantages will weaken over time as a result of the highly concentrated customer base to which it sells. As display glass increasingly becomes a commodity, these customers should be able to exert increasing pressure on Corning. A large cash position should cushion the impact of any change in its competitive position, but the firm has been spending aggressively on share repurchases lately.
We would rather hold the longer-term debt of firms that we believe have stronger sustainable competitive advantages, all else equal. Corning's existing 5.75% notes due 2040 currently trade at a spread of about 182 basis points above Treasuries. This level is spot-on with the spreads offered on the longer-term debt of both Juniper Networks (ticker: JNPR, rating: A) and Hewlett-Packard (ticker: HPQ, rating: A). Juniper's 5.95% 2041 notes trade at about 179 basis points above Treasuries, and HP's 6.0% 2041 notes trade near 182 basis points above Treasuries.
As with Corning, we've placed a narrow economic moat rating on both of these firms. Unlike Corning, though, we believe Juniper and HP will enjoy a more stable competitive position over time. HP gains stability from the diversity of its business and its growing strength in enterprise technologies and services. We expect that Juniper's place in the carrier routing market will remain stable because of the barriers that carriers face in taking on new equipment vendors.
We view Juniper and HP debt as more attractive than the new Corning offering, assuming the deal prices in line with the firm's existing notes. We'd be interested in the Corning notes only if they were priced at 210 basis points above Treasuries or greater.
Barclays Plans New Three-Year Notes (Feb. 15)
Barclays (ticker: BARC, rating A-) announced Wednesday that it plans to issue new benchmark three-year notes. No information has been given on price guidance yet. Barclays' current three-year trades with a spread above Treasuries of about 215 basis points, so we would expect this new deal to price in the area of 230 basis points above Treasuries. We think these bonds make sense at that level, given that HSBC's (ticker: HSBA, rating: A+) recently issued three-year notes trade at 175 basis points above the Treasury curve, which we view as fairly valued for a European bank.
However, if these bonds were to come in at a spread of 220 or tighter, we would recommend that investors buy the existing three-year HSBC notes with the two-notch-better rating. From a credit perspective, while Barclays came through the financial crisis in better shape than many of its peers, it is having trouble gaining traction in the post-crisis world. Despite picking up Lehman for a depressed price and escaping a government bailout, profitability has lagged, and we think it only will improve to mediocre at best. The company has sought to shed unprofitable businesses in order to boost its profit margin, but we are concerned that Barclays will remain overly dependent on its investment bank.
HSBC, on the other hand, is among the best-capitalized global banks, especially considering its lower-risk business model. We're especially fond of HSBC's strong deposit funding base, which is much more stable than the wholesale funding used extensively by most of its peers.
Joscelyn MacKay does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.