Draghi Pulls Off a Stick Save
The ECB must weigh several important implications as it contemplates following through on the market intervention implied by its president last week.
Just as it started to look like the Spanish bond market was about to come unraveled, Mario Draghi, president of the European Central Bank, stepped in to save the day. Spanish bond yields spiked at the beginning of last week and hit new highs. On Thursday, Draghi was quoted as saying that the risk premia inherent in widening sovereign spreads was impeding monetary policy transmission, and addressing this risk premia is thus within the ECB's mandate.
The markets construed his comments to mean that the ECB would intervene in the markets and begin purchasing Spanish bonds through the Securities Markets Program. Bond traders immediately began purchasing Spanish bonds to essentially front-run ECB buying, pushing the yield on two-year Spanish bonds down to 5.30% from a midweek high of 6.64%, and the Spanish 10-year down to 6.74% from a midweek high of 7.62%.
The ECB's next policy-setting meeting is Thursday, and by making such comments publicly, we think Draghi has forced his own hand. Essentially the ECB will have to follow through on purchases, lest it risk disappointing the markets. If the ECB doesn't follow through with purchases, we expect that yields on Spanish bonds would skyrocket to new highs.
As the ECB contemplates this action, there are several important implications it must weigh. For example, how much money is the ECB willing to commit to this program, and over what time frame will it buy bonds? In addition, investors may become concerned that these purchases would effectively subordinate their own holdings. When Greece conducted its private securities involvement (PSI) program, it haircut the principal of bonds held by the public, but did not reduce the principal of bonds held by the ECB. This effectively crammed down the public holders of those bonds, as the entire restructuring fell upon their shoulders. Should the purchases of Spanish bonds begin to rise too much, investors with significant holdings may decide to utilize the ECB's bid to exit their positions. This in turn would increase the amount of subordination on remaining holders (thus lowering the recovery of those bonds in a restructuring scenario). Or, yields could back up if the ECB does not have the fortitude and staying power to buy bonds if a deluge of sellers turns out.
Unfortunately, it appears that other than buying bonds in the secondary market, the ECB's hands are mostly tied. The ECB is prohibited from directly financing governments, and we are at least several months away from German ratification of the European Stability Mechanism (ESM). In addition, there is the risk that Germany will not be able to approve the ESM if its constitutional court finds that the program violates German law. If the German constitutional court were to rule against the ESM, we're not sure what tricks the eurozone has remaining up its sleeve.
Further clouding the picture, Moody's announced that it placed the Aaa ratings of several core European countries, including Germany, on negative outlook. This is a wake-up call to many German politicians and the populace, as it highlights the costs of the eurozone crisis to Germany. A rating downgrade could be enough to sway Germany against supporting future bailout programs. In fact, either the rejection of the ESM or a downgrade could instigate a scenario that begins a path for Germany to leave the eurozone and return to the Deutschemark.
After Draghi's remarks were made public, there were several reports that Spain was about to formally request a EUR 300 billion rescue program. This bailout would have been in addition to the EUR100 billion that has already been approved to help recapitalize Spain's banking system. Other wild cards that are still outstanding that could swing market sentiment include renewed negotiations between the Troika and Greece.
While ECB open market purchases may help contain the yields on Spanish bonds in the short term, it will require a delicate balance by the ECB to allay the market's fear's of becoming subordinated. Over the medium term, we continue to think that the sovereign debt crisis will continue to ebb and flow, driving market volatility until losses in the banking system are recognized, quantified, and ring fenced. Once these losses are contained, policymakers over the long term will need to equalize the structural differences among each country's regulatory regime and differences between employee productivity from one eurozone member to another.
Closer to home, the Federal Reserve is being forced to act. The market has interpreted a news article from a Wall Street Journal reporter--who is reportedly close to the Fed officials--that the Federal Open Market Committee will vote to institute a new round of quantitative easing this week. From market participants we've talked to, it seems to be a foregone conclusion that the Fed will act next week and that the only questions remaining will be the size of the plan, the types of securities the Fed will purchase, and the rate at which the Fed will buy. While QE3 may temporarily lift the prices of risk assets, it appears that the typical mechanisms that transmit monetary policy to the broader economy are no longer working. We suspect that the Fed will look to announce and implement new policies in an attempt to address the transmission issue. We fear that with so much of the market's sentiment focused on potential actions from the Fed and ECB, failure to act or put a large enough program in place could cause significant downside volatility.
While Rumors of Central Bank Actions Move the Markets, Earnings Reports Sway Individual Issuers
Rumors of central bank actions may drive market sentiment as a whole, but earnings season is in full swing, and we saw several instances where trading levels were significantly affected by results. For example, Sprint's (S, rating: B+) bonds rallied after the release of its second-quarter results. The firm's 6% senior notes due 2016 increased significantly. We continue to believe that the firm's bonds are worthy of holding, but not necessarily a best idea for new money. Sprint took a step forward in its turnaround efforts during the quarter and delivered improved margins despite Network Vision spending and strong iPhone sales. The firm also managed to generate positive cash flow--about $200 million during the quarter--enabling it to cut net debt for the first time in a year.
Telefonica's (TEF, rating: BBB-) bonds recovered a significant amount of their recent losses due to a combination of specific actions the firm has taken to shore up its balance sheet, as well as market exuberance over the rally in Spanish bonds. The firm's earnings report was soft, but Telefonica suspended its dividend and share repurchase program. We believe the decision to halt the dividend demonstrates Telefonica's commitment to ensuring it hits leverage targets over time, if not during 2012.
On the downside, RadioShack (RSH rating: UR-) spreads gapped about 300 basis points wider as the firm reported a massive decline in gross margins, resulting in an operating loss for the quarter. Our issuer credit rating is currently under review for possible downgrade. Prior to this earnings report, our B- rating was two notches below the rating agencies.
We also saw Weatherford's (WFT, rating: BBB-) bonds widen by 20 basis points as the firm reported declining margins, issues surrounding tax errors, and goodwill impairments. We expect third-quarter results to better showcase the strength in Weatherford's artificial lift product line, which should be doing well in this environment as the negative effects of the Canadian breakup roll off. However, we take a slightly more pessimistic view of the company's credit risk than the rating agencies, as our issuer credit rating is one notch lower.
LIBOR Manipulation May Have Pressured Municipal Issuers
Contributed by Candice Lee, Municipal Credit Analyst
Amidst the flurry of news regarding the alleged manipulation of the London Interbank Offer Rate (LIBOR), states including New York, Florida, and Connecticut are following on the heels of municipalities such as the City of Baltimore, by launching inquiries into whether they suffered financial losses as a result of rate-fixing, and potentially taking legal action. LIBOR affects an estimated $50 billion-$100 billion in municipal debt, and an artificial lowering of the rates could have cost municipal issuers hundreds of millions of dollars. Barclays PLC has already been fined more than $450 million for submitting lowball rates for LIBOR; it remains to be seen whether other banks will be charged for collusion in LIBOR rigging.
In floating-to-fixed interest rate swaps associated with LIBOR, issuers hedge variable rate risk by paying a bank counterparty a fixed rate in exchange for a variable rate pegged to a benchmark such as LIBOR, which was meant to mirror the yield on the variable rate debt. These swaps were commonly used for auction rate securities (ARS) and other variable-rate debt obligations because they created synthetic fixed-rate debt that was easier for municipal issuers to budget for. In low-rate environments, however, these swaps are costly for issuers, as they are on the hook for both the fixed rate owed to the counterparty as well as the variable-rate yield spread.
LIBOR manipulation created an artificially low rate environment; when liquidity dried up in 2008 and sent ARS yields soaring, LIBOR did not go up by the same extent. The Securities Industry and Financial Markets Association (SIFMA) municipal swap index is another benchmark index commonly used in interest rate swaps. Unlike the LIBOR, which is determined daily by bank submissions of estimated borrowing costs, SIFMA is based on actual rates that issuers pay investors. During the financial crisis, SIFMA jumped from 1.63% to 7.96% in September 2008, while LIBOR went from 2.49% to 3.43% over the same period, peaking at only 4.36% in October 2008 before dropping with SIFMA after the injection of liquidity from the Federal Reserve in November and December. The lower LIBOR was costly for obligors with LIBOR-related swap exposure, as they received a lower rate from the counterparty, but were on the hook for the fixed rate owed to the counterparty as well as the spread between LIBOR and the higher ARS yield.
Generally, we view the variable rate swap exposure of an issuer's debt profile with caution because it can make the issuer more susceptible to risk. It does not necessarily imply poor credit quality, but as evidenced by some of the financial troubles that faced Jefferson County, Ala., earlier this year, an extensive swap portfolio can create an unyielding debt burden for some issuers. The current low-rate environment has forced borrowers with variable-rate swaps to pay higher debt service costs, at a time when revenues at state, local, and enterprise levels are increasingly strained. Termination costs for unwinding these swaps are high, and many entities are unable or unwilling to pay these costs.
New Issue Notes
Bristol Offering Fairly Valued Notes to Fund Amylin Acquisition (Published July 26)
Bristol-Myers (BMY, rating: AA+) plans to offer benchmark-size five-, 10-, and 30-year notes in an effort to fund the recently announced acquisition of Amylin (AMLN) in collaboration with AstraZeneca (AZN, rating: AA) for about $7 billion in cash and assumed debt. Structurally, the deal is set up with Bristol purchasing Amylin and then AstraZeneca paying Bristol $3.4 billion to control half of the profits derived from Amylin products. By splitting the deal, both firms will be paying less than one year's worth of free cash flow. Neither firm's cash flow cushion moves enough to change the pillars that inform our credit ratings, and even after the deal closes, Bristol should remain one of the lightest leveraged firms in the large pharmaceutical space with debt standing at only about 1 times EBITDA.
In terms of valuation, the average AA firm's 10-year notes trade around 80 basis points above Treasuries, so guidance for Bristol's notes appears about fair. Currently, the five-year is expected at 50 basis points above Treasuries, the 10-year is expected at 75 basis points above Treasuries, and the 30-year is expected at 100 basis points above Treasuries. While we expect these notes to be paid in full by Bristol, we don't find them particularly compelling from a valuation standpoint. In general, we believe income-focused investors should look outside the large pharmaceutical industry's debt offerings to other niches in the health-care industry, or even to the large pharmaceutical firms' equities.
For those who can only invest in debt securities, we'd point to the biotech and device industry for value; our best ideas in those niches include Amgen (AMGN, rating: AA-) with its 10-year notes trading at 140 basis points above Treasuries and Zimmer (ZMH, rating: AA) with its 2021 notes trading around 135 basis points above Treasuries. For income-focused investors who also can invest in equity securities, we'd point out that all of the large pharmaceutical firms offer dividend yields higher than their five- to 10-year bond yields. For example, Bristol's dividend yield currently stands at 3.9% while its new bond issue is projected to come in around only 2.2%.
IBM's 10-Year Issuance Doesn't Look Attractive (Published July 25)
IBM (IBM, rating: AA-) is once again in the market, looking to issue 10-year notes, its longest-dated offering of the year. The firm issued three- and seven-year notes in May at 41 and 68 basis points above Treasuries, respectively. Last February, the firm issued three- and five-year notes at 37 and 57 basis points above Treasuries, respectively. Spreads on IBM debt have tightened considerably since the firm reported fairly solid second-quarter earnings last week. The firm's 2.9% notes due 2021, issued last fall, have been trading around 61 basis points above Treasuries, down from mid-70s prior to the earnings announcement. IBM reported relatively weak sales for the quarter, but increased its profit forecast for the year, bucking the broad weakness seen across much of the tech sector. At current spreads, however, we don't believe the firm's debt is attractive. The typical AA rated issuer in the Morningstar Corporate Bond Index offers a yield of about 80 basis points above Treasuries. We believe that IBM is very well positioned to prosper over the long run, but the firm continues to spend more on dividends and share repurchases than it is generating in free cash flow. Leverage has slowly climbed higher as a result.
If the new IBM 10-year is offered at a spread of 70 basis points or more, we'd start to get interested. Otherwise, we'd prefer to take on more risk within the tech sector in exchange for significantly wider spreads. We continue to like Hewlett-Packard (HPQ, rating: A). The firm's 4.05% notes due in 2022 currently trade at a spread of about 285 basis points above Treasuries. Among tech firms with exceptionally strong balance sheets, we would look to Cisco (CSCO, rating: AA) over IBM. Cisco's 4.45% notes due 2020 trade at about 91 basis points above Treasuries.
Daimler North American Finance to Issue Three- and Seven-Year Bonds (Published July 25)
Daimler AG (DAI, rating: BBB+) subsidiary Daimler Finance North America is in the market once again with a multitranche benchmark bond offering. We view Daimler's finance subsidiaries as a similar credit to the parent, given the inextricable link between the two, and the guarantees in place. We also view Daimler as a slightly weaker credit to Volkswagen (VOW, rating: A-). As such, we would expect a concession to Volkswagen's trading levels.
Volkswagen Finance issued three-year bonds in March at a spread of 114 basis points above Treasuries, and these bonds are currently indicated at about 103 basis points above Treasuries. Daimler Finance's three-year bonds issued in April at a 108 basis point spread, are now indicated at a spread of 115, which we view as roughly fair value to Volkswagen. Volkswagen's 2020 maturity bonds are indicated at a spread of 154 basis points, while Daimler's 2021s are at the same level. We view fair value on Daimler about 15 to 20 basis points wider than Volkswagen. Adjusting for the curve, we see fair value on the new seven-year Daimler bonds as roughly on top of the existing 2021 bonds. We also note that fairly valued Honda (HMC, rating: A) subsidiary American Honda Finance has 2015 maturity bonds indicated at about 96 basis points above Treasuries, and its 2021s at a spread of 140. We continue to prefer Ford Motor Credit (BBB-), which has three-year bonds indicated at about 240 basis points above Treasuries and 2021 maturities at a spread of 345.
Daimler AG just reported second-quarter results, with EBIT down 13% from the prior-year period on a 10% revenue increase. Margins were impacted by increased investment in product. The firm reiterated its guidance for flat 2012 operating results versus 2011, which is reasonably good considering the extreme weakness in Europe. The firm reported free cash flow of EUR 1 billion, and retained solid liquidity. Daimler benefits from its focus on luxury products, geographic diversity, and significant exposure to the truck market.
FedEx Corp Expected to Issue $1 Billion of 10- and 30-Year Notes; Initial Price Talk Sounds Fair (Published July 24)
We're hearing that FedEx (FDX, rating: BBB) intends to tap the bond market for $1 billion, split among 10- and 30-year maturities. Proceeds are expected to be used for general corporate purposes, potentially to fund aircraft purchases. We're hearing whisper talk in the area of 150-155 basis points over Treasuries for the 10-year and 25 basis points wider for the 30-year, which sounds fair, too. However, FedEx is a relatively infrequent issuer, so we expect final pricing to tighten in from these levels. The company has an existing 8% due 2019 that we recently saw quoted around a spread of 160 basis points over Treasuries, which we think reflects a decent premium due to its high dollar price of 133.
Rails likely offer the best comps, in our view, given the similar credit ratings and difficult-to-replicate networks. We have an overweight rating on CSX Corp (CSX, rating: BBB+), which has a 2021 bond that was recently quoted around a spread of 145 basis points over Treasuries. In addition, we have an underweight rating on Norfolk Southern (NSC, rating: BBB+), which has a 2022 bond that was recently quoted around a spread of 115 basis points over Treasuries. Adjusting for FedEx's one notch lower rating (although we view the company as strongly positioned within its rating), we would put fair value for a new 10-year in the area of 145 basis points over Treasuries and wouldn't chase the new deal much tighter than that.
FedEx's massive international shipping network would be difficult and costly to duplicate, earning the company a narrow economic moat. In fact, we believe no firm will try to replicate a global shipping network anytime soon, given the massive financial losses one would incur while trying to develop sufficient volume to cover the high fixed costs of such a system. FedEx is one of only two titans in U.S. domestic and international parcel shipping, with United Parcel Service (UPS, rating: A+) being the other, and rational pricing has been the result. We don't anticipate this will change.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.