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Credit Insights

Trading Activity Muted as Investors Await Earnings

Corporate bond trading activity was relatively light as many investors decided to wait for the calendar to build this week as reporting season ramps up.

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Although most on-the-run names felt relatively flat last week, the Morningstar Corporate Bond Index tightened 2 basis points to +116. The amount of new issues priced last week in the investment-grade segment was respectable; however, since most U.S.-domiciled issuers are in their quiet period before they release fourth-quarter earnings, a significant portion of those that tapped the market last week were Yankee issuers. Trading volume was relatively light as many investors decided to wait for the calendar to build this week as reporting season ramps up. According to several syndicate desks, many issuers are planning on quickly coming to market after their earnings release. In the high-yield market, we are hearing that it's become a food fight for investors to obtain bonds from new issue allocations, as some deals are reported to be a ridiculous 10-15 times oversubscribed. The demand for high yield has continued to increase as investors reach for yield, pushing the credit spread of the Bank of America Merrill Lynch High Yield Master Index down to +387, its lowest level over the past few years. Combined with low interest rates, the all-in yield for this index is currently a paltry 5.36%.

In the secondary market, trading activity appeared to be picking up for bonds issued by  Zions Bancorp (ZION) (rating: BBB-, narrow moat). Chris Baker, our bank sector credit analyst, published a note Thursday detailing why he thought the notes were attractive. While Zions' bonds are not for the faint of heart, Baker believes buyers of BBB bank paper should consider the 4.50% senior notes due March 27, 2017, which are indicated at 175 basis points above the nearest Treasury, or the Regions Bank 7.50% subordinated debt due in 2018, indicated at +161, as we believe these notes would be structurally senior to holding company debt in a Title II liquidation. Relative to where Zions' peers are trading and our view of the credit risk, we think both bonds are trading at attractive levels. 

 Mondelez International's (MDLZ) (rating: BBB, wide moat) bonds were under pressure Friday morning after the New York Post indicated that activist investor Nelson Peltz is weighing a proxy fight to nominate himself and several others for board seats. Mondelez tapped the market two weeks ago and issued 5-year and 10-year bonds to fund a tender offer. We thought the whisper talk on the 10-year was more than fully valued at +115 and recommended that investors pass on the offering if the final pricing was any tighter. In our new issue note, we highlighted that in addition to credit risk inherent in the company's operations, Peltz has taken a large stake in Mondelez and had been prodding the company to take actions to bolster shareholder value. Thus far, his plans have ranged from cutting costs to improve operating margins to selling the company outright. Mondelez has stated its goal to increase margins by 500 basis points over the next five years, and we suspect it is more interested in being an acquirer than being acquired. We would not be surprised to see Mondelez conduct large, debt-funded acquisitions in the future that could pressure its credit rating.

Spanish and Italian Sovereign Debt Hitting Multiyear Lows
The yields on peripheral sovereign debt have dropped to their lowest levels and spreads since before the Greek debt crisis. Since the end of 2012, the yield on 10-year Italian bonds has dropped 68 basis points to 3.82% and its spread over German bonds has declined 111 basis points to +207. The yield on 10-year Spanish bonds has dropped 156 basis points to 3.71% and its spread over German bonds has declined almost 200 basis points to +197. The economic deterioration in Spain appears to have bottomed out, and the country's economy has recently begun to slowly expand. Spain reported that its fourth-quarter gross domestic product rose 0.3%, an acceleration from 0.1% in the third quarter. However, we caution that Spain is not completely out of the woods, as nonperforming loans there have continued to rise and unemployment at 26.7% remains near its highest levels.

Among the other countries that required financial bailouts, Ireland recently returned to the public capital debt markets and issued EUR 3.75 billion of 10-year bonds at 3.54%, representing a 140-basis-point spread over mid-swaps. Demand for the new issue was high as the order book was reportedly almost 4 times oversubscribed. Ireland's successful offering helped to propel Portugal's bonds higher as Portuguese officials evaluate tapping the public debt markets to auction their own new issue.

After cutting its main short-term rate by 25 basis points last November, the European Central Bank held it steady at its January meeting. However, ECB President Mario Draghi committed to keeping monetary policy loose for the foreseeable future and taking decisive action, including unprecedented actions, if the European economy were to stumble. The ECB may also look to instituting its own quantitative easing program if inflation decelerates from its current 0.8% rate. The ECB targets a 2% inflation rate but has fallen well short of that goal over the past year.

Click to see our summary of recent movements among credit risk indicators

New Issue Notes

RBC's 3-Year Price Talk Is Attractive (Jan. 15)
 Royal Bank Of Canada (RY) (rating: AA-, narrow moat) is in the market with a benchmark-size offering of 3-year fixed- and floating-rate senior notes. Initial price talk is in the high-40-basis-point range over Treasuries, which we view as attractive. We expect the deal to price in the low-40-basis-point range over Treasuries, which we would view as fair. Price talk on the new 3-year notes would provide an attractive new issue concession to the current 3-year dollar-denominated issue, the 1.45% due Sept. 9, 2016, which is indicated at +32 basis points to the nearest Treasury. The large Canadian banks usually trade in a narrow range because of their similar business models, regulatory environments, and ratings.  Toronto Dominion Bank's (TD) (rating: AA-, narrow moat) 1.40% due April 30, 2018, is indicated at +45 basis points to the nearest Treasury, which we view as fairly valued, while lower-rated  Bank of Montreal's (BMO) (rating: A, narrow moat) 2.50% due Jan. 11, 2017, are indicated at 52 basis points over Treasuries, which we view as fair for the rating.  Bank of Nova Scotia (BNS) (rating: A+, narrow moat), which falls in the middle of the rating spectrum, is indicated at 44 basis points over the nearest Treasury on its most recent 3-year issue, the 1.375% due July 15, 2016, which we view as slightly expensive.

RBC has been a consistent performer throughout the financial crisis, thanks largely to its solid foothold in Canadian banking and capital markets, where it derives about 75% of net income. Returns on equity in the Canadian banking segment have been in excess of 30% in each quarter since 2007. Return on equity for the entire company in 2013 and 2012 averaged an impressive 19.3%, one of the highest in our bank coverage list. Solid capital is another hallmark of RBC's credit quality. Common equity Tier 1 is 9.6%, and Tier 1 is 11.7%. We have few concerns regarding RBC's ability to expand its capital base and comply with regulatory capital requirements. However, we are concerned that future earnings will diminish due to the runup in Canadian household debt as a percentage of disposable income, which has increased to more than 160% from 50% in the mid-1980s and 90% in 1990. Furthermore, we have concerns about overpriced housing in Canada and its eventual impact on the Canadian banking segment.

Click here to see more new bond issuance for the week ended Jan. 17, 2014.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.