August Doldrums Settle In, but Risk Rumbling in the Near Distance
Underlying market technicals continue to support corporate bonds, but renewed risk from a weakening global economy and systemic risk from sovereign issues hover on the horizon.
Corporate bond trading desks reported that activity was brutally quiet last week as the August doldrums finally settled in. New issue activity was virtually nonexistent, and secondary trading was tough to come by, as it became increasingly difficult to source bonds and inventory on dealer desks remains near its lows. Credit spreads were largely unchanged over the course of the week, as the few issuers that experienced idiosyncratic weakness were offset by continued demand across the rest of the market.
Underlying market technicals continue to support corporate bonds, even though rumblings of renewed risk--emanating from a weakening global economy and systemic risk from sovereign issues--are sounding closer as we approach September. Treasury bonds regained some of their appeal last week, driving prices back up as the yield on the 10-year and 30-year bonds dropped 16 basis points to 1.66% and 2.77%, respectively.
Clients that we met with last week mentioned that they still have abundant amounts of cash that they need to put to work. However, most are very cautious about adding additional risk into their portfolios and have been looking to trade up in quality. With the dearth of offerings available, many portfolio managers have begun to take the opportunity to clean up their books and offer out for sale bonds of those issuers to which they want to reduce exposure.
Storm Clouds Gathering on the Horizon
Federal Reserve Chairman Ben Bernanke is scheduled to speak at the annual Federal Reserve conference in Jackson Hole Friday, where many pundits expect him to allude to additional quantitative easing and new monetary policy programs intended to jump-start economic growth. If Bernanke does hint of new or additional monetary easing, the consensus among the clients we have recently spoken with is that it will provide a short-term boost in asset prices, but additional policy actions probably will not have much of an effect on the broader economy. As one client recently put it, the monetary spigot is already wide open, and opening it any further will only drown the markets with cash.
In addition to Bernanke's speech next week, Italy is scheduled to conduct several bond auctions that could test the depth of the European sovereign debt market to absorb additional peripheral debt. Further testing the market's appetite for peripheral debt, Spain is scheduled to return to the debt markets and price a new bond issue the first full week of September.
By mid-September, the credit market's focus will be on Germany's Constitutional Court, which is expected to rule on whether the European Stability Mechanism is allowable under Germany's constitution. The risk is that if Germany is unable to ratify the ESM, it will take the eurozone back to square one in figuring out a way to finance the deficits and maturing debt of the peripheral countries. If the German constitutional court rules against the ESM, we're not sure what tricks the eurozone has remaining up its sleeve.
Assuming the ESM is constitutional under German law, the market will focus on the plan and structure to bail out the Spanish banks. Spanish banks continue to increase their borrowings from the European Central Bank as they are essentially shut out of the public capital markets. It's still unclear as to the structure of the bailout offered to the Spanish banks and whether this debt will have to be guaranteed by the Spanish government, which would increase the country's debt/GDP ratio. In conjunction with uncertainty around the impact of a Spanish bank bailout on Spain's credit quality, Moody's may conclude its rating evaluation of Spain. Moody's had placed its Baa3 rating under review for possible downgrade in June, and we are approaching the three-month window in which Moody's usually concludes its rating reviews. Also, the ongoing negotiations with Greece to allow the next installment of bailout funds should be concluded in September.
Pension Woes Continue for Illinois
Contributed by Beth Foos, Municipal Credit Analyst
State of Illinois lawmakers failed to enact meaningful pension reform during a recent one-day special session, which further pressures the state's financial flexibility and overall credit quality. The General Assembly was called to meet Aug. 17 by Gov. Pat Quinn to consider changes to the state's significantly underfunded pension systems after legislators failed to act on the issue in their regular spring session. Again, no vote was taken and further discussion of reform isn't expected until after the November elections. Quinn warned that more inaction on pension issues will further affect the state's ability to deliver basic services, including adequately funding education both at the local and university levels. It's estimated that Illinois' unfunded pension liability, which hit $82.9 billion in fiscal 2011, grows by $12.6 million every day.
Funding the state's five retirement systems is a huge financial challenge for Illinois. Under Illinois Pension Code, the state is required to make annual contributions to each pension system, including most of the required employer contributions for the State Universities Retirement System and the Teachers' Retirement System. All of the systems have been chronically underfunded for many years. By 1995, the aggregate unfunded liability was almost $20 billion and ballooned to $82.9 billion as of June 30, 2011. The rapid growth in liability is mainly due to benefit enhancements, lower investment returns, changes in the actuarial assumptions, and the "50-year payment plan," which allows the state to defer larger payments for decades.
In 2010, Illinois enacted some pension reform, which, among other things, raised the retirement age and created a two-tier benefit system that reduced benefits for future employees. Management reports that these reforms are projected to decrease the actuarial accrued liability somewhat, yet a great deal of work needs to be done to stabilize the systems' current fiscal health. At the end of fiscal 2011, the aggregate funded ratio for all five systems was a very low 43.3%. Even with reform in 2010 and an escalating payment schedule, the aggregate funded ratios for the pension systems are projected to remain below 50% through 2020. Morningstar considers a funded ratio below 70% to be a warning sign of potential credit pressure.
The state's annual required contribution, which was about $4.3 billion in fiscal 2011, is expected to increase by more than $2 billion to nearly $6.5 billion per year by 2014 and continue its climb through 2045. This represented 12% of general fund spending in fiscal 2011 and is estimated to grow to more than 20% of general fund spending by fiscal 2013. Proceeds from the sale of general obligation bonds helped pay a portion of the state's annual pension costs in fiscal 2010 and 2011, yet existing reserves are slated to be used for contributions in 2012 and 2013. Meeting these rising costs has forced the state to delay payments on other bills contributing to its overall accumulated deficit and is expected to force cuts to education funding in future budgets. Without meaningful reform soon, the state's pension liabilities will further pressure Illinois' financial flexibility and credit quality and possibly threaten support of basic services.
New Issue Notes
Illinois Tool Works' New 30-Year Issue Will Probably Be Fairly Valued (Aug. 21)
We're hearing that Illinois Tool Works (ITW, rating: A) is going to access the bond market today, looking to raise $500 million of 30-year money. Proceeds are expected to be used for general corporate purposes, including paying down outstanding commercial paper borrowings, which stood at $1.3 billion at the end of June. We recently downgraded our issuer rating on ITW to A from A+, reflecting deterioration in our Cash Flow Cushion score due to a combination of increased share repurchases and a reduction in our forecast earnings and cash flow. We think shareholder-friendly actions, such as share repurchases, are likely to continue, particularly given increased involvement from activist investor Relational Investors. To that end, ITW management recently announced the sale of a 51% stake in its laminate business, which is expected to bring in about $1 billion of cash, the majority of which is likely to be used for share repurchases.
Whisper talk on the new 30-year bonds is 120-125 basis points over Treasuries, which sounds slightly cheap relative to other A rated diversified industrial names. For comparison purposes, Honeywell (HON, A), which we think trades rich, has a 2041 bond that was recently quoted around a spread of 95 basis points over Treasuries. United Technologies (UTX, A), which we view as closer to fair value, has a 2042 bond that was recently quoted around 105 basis points over Treasuries. We would expect price talk on the new ITW bonds to tighten, and if the new deal comes around a spread of 115 basis points over Treasuries, we would view that as fair value for the sector.
We Expect Fidelity National's New 10-Year to Price Attractively (Aug. 21)
Fidelity National Financial (FNF, rating: BBB) announced Tuesday that it plans to issue $400 million of new benchmark 10-year notes. No information has been given on price guidance yet. Considering Fidelity National's 5-year trades with a spread above Treasuries of approximately 380 basis points, and also factoring in a new issue concession along with the 5-year to 10-year credit curve in the finance sector, we expect this new deal to price in the area of 400 basis points above Treasuries. We think these bonds make sense at that level, and we would recommend them all the way down to a spread of 350.
From a credit perspective, we like the company's strong operating performance, but we are wary of its comparably higher debt levels and the amount of goodwill on its balance sheet. As a leader in the title insurance market, Fidelity has a narrow economic moat, in our opinion. Lenders require title insurance, so instead of using resources to stimulate demand for the product, marketing is focused on gaining share through numerous large acquisitions. Most of Fidelity's revenue is from title insurance policies, which are a necessary function in the U.S. real estate transfer process.
Through aggressive cost-cutting, price increases, and negotiating better deals with agents, Fidelity was able to generate 8% underwriting margins in its title insurance operations over the past two years. But the profits came at the cost of losing 25% of its market share over the past four years. While we like the company's core operations fundamentally, we do have some concerns over capital allocation, specifically management's decision to expand into the restaurant industry through acquisitions. We see no valid strategic reason for this move, and think management is diluting the company's moat. Fidelity National Financial carries slightly higher debt leverage as evidenced by its debt/capital ratio of approximately 0.29, where First American Financial (FAF, BBB+) has a debt/capital ratio of about 0.21. Also, goodwill and intangible assets account for 40% of shareholders' equity, which we have factored into our rating on Fidelity National.
LabCorp Refinancing Could Be Attractive for Investors (Aug. 20)
LabCorp (LH, rating: BBB+) plans to issue 5-year and 10-year notes primarily to refinance its revolving debt facility ($450 million outstanding at end of June) and other general corporate purposes. We don't anticipate changing our credit rating based on this new issuance. In general, we view spreads on LabCorp's existing notes as attractive from a valuation standpoint. For example, its 2016 and 2020 notes recently traded at a spread of 145 and 207 basis points over Treasuries, respectively. For comparison, the average BBB+ rated firm sports a 10-year spread around 160 basis points over Treasuries. Of note, many new health-care issues have been priced inside existing spreads in recent weeks. However, we'd have to see an extreme case of that phenomenon to even view LabCorp's new issues as merely fairly valued.
Also, in comparison to key competitor Quest Diagnostics (DGX, BBB+), LabCorp looks like a good relative value; for example, Quest's 2021 notes recently traded at 173 basis points over Treasuries, or 34 basis points tighter than LabCorp's 2020 notes and much closer to what we'd deem as fair for a BBB+ rated firm. As a duopoly, we view Quest and LabCorp similarly from a business quality perspective, giving them each a narrow economic moat. With that view and LabCorp's less leveraged balance sheet (at the end of June, LabCorp operated with a debt/EBITDA position of 1.6 while Quest operated with an inflated debt/EBITDA position around 2.5 times due to recent acquisitions), we see no reason for the credit markets to differentiate so much between those two organizations. We think investors would be wise to consider LabCorp's new issue, especially if these relative valuation characteristics are evident in today's pricing.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.