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Credit Insights

Credit Spreads Widen on Emerging-Markets Turmoil

At this point, the instability appears to be contained in relatively small geographic regions.

The average credit spread in the Morningstar Corporate Bond Index widened 6 basis points to +128 last week and has increased a total of 9 basis points for the month. This minor pullback has been uncomfortable, but considering that credit spreads were at their tightest levels since before the 2008-09 credit crisis earlier this month, we are not too concerned that these slightly wider spreads will affect either the availability of credit to corporations or trading liquidity. 

The banking sector took the brunt of the losses, widening 14 basis points on average in January. The transportation sector fared the best, as the average spread in the sector tightened 4 basis points for the month. Even though credit spreads have widened thus far this year, the Morningstar Corporate Bond Index has risen 1.57% because of the decline in interest rates. As turmoil erupted among several emerging markets and currencies plunged in those countries, investors flocked to the safety of U.S. Treasury bonds, pushing the yield on the 10-year Treasury down 36 basis points to 2.67%.

At this point, the instability appears to be contained in relatively small geographic regions; the volatility in the foreign exchange markets has been concentrated in Turkey and Hungary in Europe, Argentina and Venezuela in Latin America, and South Africa in Africa. As long as this instability remains focused in only a few countries that have relatively small economies, the impact to the U.S. corporate bond market should be limited. We would become concerned only if the contagion spreads wider and begins to infect broader geographic areas, moving into China or the developed markets. In that case, credit spreads could quickly widen out around 25 basis points, taking the average spread level in the Morningstar Corporate Bond Index to the top of the range that we currently consider fair value.

The new issue market was relatively silent as investors focused on the deluge of earnings releases and tried to sidestep the fallout from the weakness in the emerging markets. The reaction in the equity market to earnings reports seems to be more volatile than usual, as numerous companies have seen their stock price rise or fall by double-digit percentages. Generally, except for the minority of companies that have been able to please equity investors, top-line growth has remained sluggish, guidance has been lackluster, and a significant part of earnings growth has been low quality (that is, tax changes, addbacks, or share buybacks) as opposed to sustainable improvements in the underlying business. However, one sector that has largely reported strong earnings and improving credit risk profiles is the refining sector. David Schivell, our energy credit analyst, had highlighted his expectations for improving results in his Nov. 22, 2013 report, Industry Credit Snapshot: Refining & Marketing. He specifically identified attractive buying opportunities among select refiners given our forecast for long-term crude price differentials to stabilize.

Federal Reserve's Asset-Purchase Program to Decline by $10 Billion, to $65 Billion in February
Turmoil in the emerging markets, sinking equity prices, and widening credit spreads were not enough to dissuade the Federal Reserve from continuing to taper its asset-purchase program. The Fed cited that economic growth has picked up in recent quarters (fourth-quarter real GDP increased 3.1%), household spending and business fixed investment advanced, and labor markets have improved. In addition, while fiscal policy has been restraining growth, the Fed expects that restraint to loosen.

Economic indicators released last week were mixed, as durable goods orders and pending home sales were significantly below expectations. Offsetting these disappointments, home prices held steady and consumption grew slightly more than expected. Neither the better- nor worse-than-expected economic releases were enough to cause Robert Johnson, Morningstar's director of economic analysis, to readjust his view, as he continues to expect real GDP to grow at a 2.0%-2.5% pace in 2014.

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

New Issue Notes

Initial Price Talk on Goldman's New Issue 5-Year Is Attractive (Jan. 28)
 Goldman Sachs Group (GS) (rating: BBB+, narrow moat) is in the market with benchmark-size 5-year senior holding company bonds as well as tapping into its November 2018 floating-rate notes. Initial price talk on the 5-year notes is 120 basis points over Treasuries, which we consider attractive down to a fair value of +105. On Jan. 21, Goldman's closest competitor,  Morgan Stanley (MS) (rating: BBB, narrow moat), issued 5-year senior holding company notes at 95 basis points over Treasuries. The bonds are now indicated at +98, which we consider unattractive as we place fair value on the notes between 105 and 110 basis points over Treasuries. Also on Jan. 21, global bank  JPMorgan Chase (JPM) (rating: A, narrow moat) issued 5-year senior holding company notes at 73 basis points over Treasuries. These are now indicated at +83, which we consider fair value. Also in January, global bank  Bank of America (BAC) (rating: BBB, narrow moat) tapped into its senior holding company notes, the 2.6% due 2019, at 87 basis points over Treasuries. These are now indicated at +94, which we consider fair. Goldman's existing 5-year notes, the 2.9% due 2018, are indicated at +102 to the nearest Treasury, which we consider fair value. We believe that higher-rated Goldman should trade between 5 and 10 basis points tighter than Morgan Stanley.

The classic investment banking model came under considerable pressure during the financial crisis, ultimately leading Lehman Brothers into bankruptcy. Both Goldman and Morgan Stanley restructured as commercial banks, allowing them access to the Fed's discount window, but also subjecting them to higher regulation. The theme of increased regulation and operating restrictions continued last year with the adoption of the Volcker Rule, which limited banks' ability to trade for their own account and restricted how they could invest their capital. While we expect the Volcker Rule and other regulations to put modest downward pressure on the earnings of banks like Goldman and Morgan Stanley, we see the effect upon the two banks as roughly similar, and see no reason Goldman should price more than 20 basis points wide to Morgan Stanley

The returns on equity of more than 25% that Goldman Sachs produced before 2008 are likely to become a memory, but we expect the new Goldman will remain one of the strongest investment banks and earn above-average returns on capital. In addition to Volcker, regulations like Basel III, which increase the amount of capital that banks must maintain to absorb losses, will force the company to lower its financial leverage. In response, management will probably reallocate capital from lower- to higher-return on regulatory capital businesses. Some areas that may be pared down--such as principal investments and mortgage securitization--historically contributed to earnings volatility. Their reduction should improve earnings and balance sheet quality, leading to a more stable credit profile

Price Talk on USB's New Issue 3- and 10-Years Attractive for the Rating (Jan. 27)
 U.S. Bancorp (USB) (rating: A+, narrow moat) is in the market with benchmark-size 3-year senior bank-level notes--both fixed and floating rate--and 10-year senior holding company notes. Price talk on the 3-year fixed-rate notes is the mid-40-basis-point range over Treasuries, and we expect the bonds will price around +40. We consider this level attractive for the rating as we place fair value on the notes to be in the mid-30-basis-point range. For the 10-year note, price talk is in the mid-90-basis-point range over Treasuries. As with the 3-year note, we consider the initial price talk attractive as we consider fair value for the notes to be +90 basis points to Treasuries--also the level at which we expect the notes to price.

On Jan. 23, regional bank  PNC Financial Services Group (PNC) (rating: A-, narrow moat) issued $1 billion senior bank notes at +42 basis points to Treasuries. These notes are now indicated at +45 to Treasuries, which we consider attractive relative to fair value at +40 to the nearest Treasury. Another regional peer,  BB&T (BBT) (rating: A-, narrow moat), has bank-level 3-year notes, the 1.45% due 2016, indicated at +40 basis points to the nearest Treasury, which we consider fair value. As we've mentioned on other occasions, we prefer bank-level debt to holding company debt, as we believe bank debt to be structurally senior to holding company debt in a Title II orderly liquidation.

USB's existing 10-year note, the 3% senior notes due 2022, are indicated at +80 basis points to the nearest Treasury, which we consider slightly expensive to fair value. As a result, we consider the new issue note an attractive alternative down to +90 on its price talk or higher. Superregional peer  Wells Fargo's (WFC) (rating: A+, narrow moat) 10-year notes, the 4.50% senior notes due 2022, are indicated at +91 basis points to Treasuries, which we consider fair value, while lower-rated PNC is indicated at +114 basis points to the nearest Treasury, which we consider fair value for the rating.

USB's notes generally trade near the tightest levels of their peer group, with good reason. The regional bank, focused on traditional retail and commercial banking, wealth management, and payment processing, never posted a losing year during or since the financial crisis. Annual returns on equity since 2008 have averaged more than 13%, impressive for a bank with a low-risk business model. The bank maintains a close watch on costs and benefits from a solid efficiency ratio around 55%. Credit quality is also impressive, with net charge-offs improving to 0.54% of loans in the fourth quarter of 2013 compared with 0.85% in the year-ago period. Net interest margin is near the top of the peer group at 3.4%, while capital is solid with Basel III Tier I capital at 8.8%. These measures lead us to believe that the bank is well positioned to post solid results in the periods to come.

Click here to see more new bond issuance for the week ended Jan. 31, 2014.

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