Volatility Continues to Rule Markets
Despite the fact that company fundamentals remain supportive of spread levels, the impact of interest-rate and equity market moves was again felt in the corporate bond market.
We continue to view the corporate bond market as fairly valued, but we believe the near-term direction of spreads will be positively correlated to interest-rate and equity market moves.
Volatility continued last week as markets responded to data and central bank commentary. The positive tone set by the May payroll data carried over into last Monday, when Standard & Poor's raised its outlook on its U.S. credit rating to stable from negative. The encouraging economic data continued during the week as the NFIB Index of Small Business Optimism rose 2.3 points in May to 94.4, posting its second-highest level since the recession. Weekly jobless claims and retail sales for May both posted results that were in line with or better than expectations, though industrial production, capacity utilization, and consumer sentiment, which were all released Friday, were slightly softer-than-expected.
The mix of economic data drove yields on the 10-Year Treasury higher, then lower; they eventually finished the week close to unchanged as market participants assessed the path of future Federal Reserve policy. While the 15-basis-point yield range experienced during the week pales in comparison with the rapid move higher in yield seen in May, it serves to highlight the continuing uncertainty in the interest-rate markets. In addition, this week saw several high-profile market pundits offer their opinion about when the Fed will begin tapering its asset purchases. With both sides of the discussion strongly argued, the market will look for any hints about the Fed's intent when the statement from the two-day Federal Open Market Committee meeting is released Wednesday.
Global equity markets experienced significant volatility as well, particularly in Japan after the Bank of Japan disappointed investors by not taking additional steps to boost the economy. This resulted in a drop of 6.4% for the Nikkei followed by a rebound of 1.9%. The S&P 500 also experienced intraweek volatility, at one point trading down more than 2% from last week's close before rallying, then fading once again to end the week down just over 1%. With concern beginning to spread about the liquidity crisis in Chinese banks, equity investors, like fixed-income investors, are increasingly focused on whether global central banks will continue to provide the monetary stimulus that underpinned the global rally in risk assets.
The impact of interest-rate and equity market moves was again felt in the corporate bond market despite the fact that company fundamentals remain supportive of spread levels. Although the Morningstar Corporate Bond Index was just 5 basis points wider on the week, compared with 9 basis points last week, heightened uncertainty constrained the new issue market. The dollar volume of new debt issued by companies in Morningstar's coverage universe declined more than 50% compared with last week. We note that increasing volume of new issuance typically coincides with spread tightening. The high-yield market remained under pressure this week following the record weekly outflow of $1.8 billion from high-yield mutual funds that was reported for the week ending June 7. Amid reports from high-yield traders of reduced liquidity and widening bid/ask spreads, we believe that the asset class will remain susceptible to further price declines until a new incremental buyer enters the market to fill the void left by retreating retail investors.
New Issue Notes
Initial Price Talk for BB&T's 5-Year is Attractive (June 14)
BB&T (BBT) (A-, narrow moat) announced today that it is issuing new 5-year fixed and/or floating-rate notes. Initial price talk is a spread in the range of 110-115 basis points over the Treasury curve for the fixed-rate notes, which we view as attractive. BB&T's current five-year trades with an approximate spread of 87 basis points over the Treasury curve, which we view as fairly valued. We would recommend these new notes all the way down to a spread of +90. Anything tighter than +90 and we would recommend investors look to Wells Fargo (WFC) (A+, narrow moat) whose 5-year trades with a spread of 80 basis points above the Treasury curve. We think giving up 10 basis points in spread for a two-notch rating differential makes sense.
Morningstar's credit rating of A- for BB&T reflects the Southeastern bank's solid operating performance and conservative balance sheet. BB&T emerged from the financial crisis in a much better financial position than many of its peers, which has allowed it to gain market share and improve overall operating performance. The company's primary focus and source of funding is low-cost deposits, which fund more than 70% of assets and more than 100% of loans. We think the company's plan to acquire BankAtlantic will help it continue to grow in the Florida market--still a region with appealing demographics where BB&T already has a large presence. Combining higher-interest income from loan growth and lower expenses, thanks to a larger deposit base, will help the bank keep its interest margins at reasonable levels. While the company performed well in the crisis, it did experience a pickup of nonperforming assets. Recently, the bank has done well in reducing these assets, as the percentage of nonperforming assets (excluding covered assets) to total assets has fallen below 1.0%. This percentage had hit a peak of almost 3.0% in mid-2010.
PG&E to Issue $600 Million of 10- and 30-Year Bonds; Price Talk Cheap for Short End of Curve (June 12)
PG&E (PCG) (A-, narrow moat) announced today that it will issue in aggregate $600 million of 10-year and 30-year bonds. Initial price talk is 115 basis points over the 10-year Treasury and 130 basis points over the 30-year Treasury. When compared with peers Xcel Energy's (XEL) (BBB+, narrow moat) 4.7% due 2020 trading at 102 basis points over the seven-year Treasury and Wisconsin Energy's (WEC) (A-, narrow moat) 6.2% due 2033 quoted at 140 basis points over the 18-year Treasury, PG&E's 10-year bond appears fairly cheap while its 30-year bond appears slightly rich, especially given its longer tenor compared with Wisconsin Energy. We believe fair value on PG&E's 10-year is roughly 100-105 basis points over the 10-year Treasury while fair value on its 30-year is roughly 145 basis points over the 30-year Treasury (approximately 5 basis points of pickup for 20/30 differential).
While PG&E remains exposed to approximately $1.0 billion of additional unrecoverable costs related to the San Bruno, Calif., pipeline explosion ($1.4 billion spent as of the first quarter), we believe it operates in a generally constructive regulatory environment with an above-average allowed return on equity of 10.4% and a 52% equity capitalization. Moreover, PG&E continues to expand its stable regulated electric rate base as it projects roughly $5.1 billion of infrastructure spending in 2013. We expect PG&E to raise roughly $1.0 billion of additional equity to partially offset its remaining San Bruno expenses in 2013.
For Those Searching for Yield, Price Talk for Zions' New 10-Year Is Attractive (June 10)
Zions Bancorporation (ZION) (BBB-, narrow moat) announced today that it is issuing new 10-year senior notes. Initial price talk is a spread in the area of 240 basis points over the Treasury curve, which we view as attractive. Given our concerns regarding Zions' loan book, we can only recommend these bonds down to a spread of 190 basis points over the Treasury curve. Anything tighter than +190 and we would recommend investors look to Morgan Stanley (MS) (BBB, narrow moat) and give up approximately 20 basis points in spread for a one-notch better rating.
We like Zions' footprint, as it operates in higher-growth markets, which should fuel its asset expansion. The company also benefits from a solid deposit base because of its strong presence in Nevada, Arizona , and its home state of Utah. This focused presence, however, leads to a concern in the loan book as Zions has nearly 40% of its loan book concentrated in California, Arizona, and Nevada. It is also largely focused on commercial lending; less than one fifth of its loans are to individuals. Although we think the worst of Zions' real estate-related charge-offs are behind it, we think loan losses still have a ways to go before they get back to near precrisis levels, especially in its commercial real estate portfolio, which includes construction and land-development loans.
Duke Energy to Issue $350 Million of 5-Year Bonds; Price Talk Close to Fair Value (June 10)
Duke Energy (DUK) (BBB+, narrow moat) announced Monday that it will issue $350 million of five-year bonds. Initial price talk is 110-115 basis points over the five-year Treasury. We note existing 6.25% Duke Energy bonds due 2018 currently trade at 107 basis points over Treasuries. We believe price talk on Duke's new five-year bonds is fair compared with the company's existing 5-year bonds, as well as compared to peer Xcel Energy's 5.613% bonds due 2017, which trade at 105 basis points above Treasuries. However, we believe
SCANA's (SCG) (BBB+, narrow moat) 6.25% bonds due 2020 offer the most attractive risk-adjusted spread at roughly 200 basis points above Treasuries; SCANA is on our investment-grade Best Ideas list.
Recent regulatory actions following Duke's merger with Progress Energy indicate the company remains on stable footing. In June, Duke Energy's most important regulatory commission, in North Carolina, approved a 10.2% allowed ROE and a $179 million rate increase for Duke Energy Progress. We believe this rate settlement affirms Duke's constructive relationship with North Carolina regulators despite the recent settlement regarding Progress' merger investigation, as the approved ROE of 10.2% compares favorably with the national ROE average of 9.8%.
David Schivell does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.