Investment Bankers Must Be on Spring Break
New issue supply fell well short of demand to put money to work last week.
As we highlighted last week, if the new issue market didn't pick up enough to satisfy the demand from new money coming into the corporate bond market, spreads would continue to tighten, and tighten they did. Even though the S&P fell 0.5% and economic data was weaker than expected, the average credit spread in the Morningstar Corporate Bond Index tightened 2 basis points to +113. Treasury bonds firmed up, and the yield on the 10-year bond fell 4 basis points to 2.71%, recapturing much of the rise in rates from the prior week.
Investment bankers must have been on spring break. The new issue market was quiet and dominated by Bank of America's (BAC) (rating: BBB, narrow moat) $7.6 billion multitranche offering. If not for the B of A deal, it would have been the slowest week in recent memory. At a spread of 97 basis points over Treasuries, the 5-year tranche provided good value for investors, as we think fair value is +85. The 10-year notes were priced at +137, almost on top of our fair value assessment, and the 30-year was priced at +137, the same level as the 10-year. Within the sector, we have seen a number of instances where the spreads on the 10-year and 30-year bonds are equivalent, but we think there should be a 15- to 20-basis-point spread between the two, and as such think fair value for the 30-year bonds is +155.
Weaker Economic Data Persists
Economic data reported last week continued to indicate that the rate of economic expansion was slowing in the developed markets and weakening in China. For example, Markit's March Flash US Manufacturing PMI declined to 55.5 from 57.1 in February, its Flash Eurozone PMI was relatively stagnant at 53.2 (just slightly below the 53.3 reading in February), and the HSBC Flash China Manufacturing PMI fell to 48.1 (an eight-month low) from 48.5. Even though the readings were sequentially lower in the United States and Europe, both were still above the 50 demarcation between expansion and contraction, thus indicating economic growth; however, China's reading was the third monthly reading below 50 and revealed that the weakness was broadly based across the inputs and that domestic demand softened further. Both output and new orders in China decreased again, following decreases in both categories last month, which according to Markit signaled the first contractions of both output and new orders at Chinese manufacturers since July 2013. Besides the PMI data, the data underlying the durable goods was worrisome. The headline increase of 2.2% was twice what economists were expecting, but underneath the positive print, a deeper analysis showed that excluding transportation, durables orders slowed to a 0.2% increase in February.
Bob Johnson, Morningstar's director of economic analysis, pointed out that housing data in the U.S. looked particularly bad. He cited slowing pending home sales and lower new-home sales, which, combined with dour builder sentiment and stagnant housing starts from the prior week, paints a picture of gathering clouds. Combining a soft market for big-ticket items like housing and slower-than-expected auto sales, Johnson often notices a bump up in retail sales as consumers have more money to spend in the stores. However, weekly shopping center data has not improved; for the past four out of five weeks, it has been under 2% growth and averages only 1.6%. While Johnson acknowledges that weather will suppress growth in the first quarter, he continues to forecast that the economy will grow 2%-2.5% for the year. Supporting his view, he points to his projection that the government sector will be a net contributor in 2014 as compared with a detractor in 2013, the boom in the oil and gas sector, and health care also contributing to growth. For greater detail on Johnson's economic analysis, please see his most recent publication, "Will the Barricades to Strong Economic Growth Ever Stop Coming?"
ECB Floats Trial Balloons to Test Market's Reaction to Quantitative Easing
Different members of the European Central Bank began to float trial balloons to test the market's reaction to beginning their own quantitative easing program in order to fight disinflation. One of the ECB's goals is to target inflation at 2%, but it has fallen well short of this goal. Inflation in the eurozone as a whole has slowed to 0.7% and in some countries has dropped below zero, indicating a deflationary environment. For example, Spain reported that its flash estimate of annual inflation of the CPI in March was negative 0.1%, a decline of two 10ths from February.
The two main mechanisms currently being tested are changing the overnight deposit rate for funds deposited with the ECB to a negative rate and beginning an asset-purchase program to buy long-term bonds. Even Bundesbank president Jens Weidmann, one of the most prominent central bankers, would not rule out taking such measures. Considering that Germany, which has a cultural aversion to risking even a hint of inflation, appears to be on board with these actions, we think it is more likely than not that the ECB will implement one or both of these measures.
By charging banks to deposit funds at the ECB, the ECB is trying to force banks to either lend short-term funds to other banks, which would provide liquidity and lower short-term funding costs for those banks, or purchase short-term sovereign bonds, which would also effectively lower rates. Similar to the asset purchase program in the U.S., the ECB may purchase longer-dated bonds in order to reduce long-term interest rates. However, considering the yield on the 10-year German bond is already at 1.55% and bottomed out at about 1.20%, it's hard to see the yield drop much further. Even Italy's and Spain's 10-year bonds, which rose above 7% during the 2012 sovereign debt and banking crisis, are now trading near their historical lows at 3.30% and 3.25%, respectively.
If the ECB does implement these measures, it could reduce the value of the euro, which has appreciated considerably versus the dollar over the past year. This depreciation would then boost exports and import inflation from other areas around the globe. As we have seen in the U.S. market, this newly created money would also find its way into the corporate bond market and could push credit spreads tighter as investors search for yield. Before the 2008-09 credit crisis in the U.S., the average spread in our Corporate Eurobond Index traded about 50 basis points tighter than the average credit spread in our US Corporate Bond Index. Currently, the spread differential is 15 basis points. So even though economic growth is stronger in the U.S., and U.S. banks are arguably better capitalized than their European peers, we could see continued outperformance in European corporate bonds.
New Issue Notes
Initial Price Talk on Bank of America's 5- and 10-Year Is Attractive, While 30-Year Is Overvalued (March 27)
Bank of America is in the market with a four-part benchmark-size offering of 5-year fixed- and floating-rate notes as well as 10-year and 30-year fixed-rate notes. Initial price talk on the 5-year fixed is 100 basis points to Treasuries while talk on both the 10- and 30-year is +140-145 basis points. We consider the price talk on the 5-year most attractive relative to fair value of +85. On the 10-year, price talk is just slightly cheap to fair value of +135 where we expect the bonds to actually launch. In general, we see the 30-year bonds as overvalued, as we would expect around 20 basis points of spread when moving from 10- to 30-year bonds, which would put fair value on the notes around +155.
In the 5-year area, BAC's 2.6% notes due in 2019 are indicated at 83 basis points to the nearest Treasury, which we consider fair. Closest peer Citigroup's C (rating: A-, narrow moat) current 5-year notes, the 2.5% due in 2018, are indicated at +74 basis points, which we consider fair. JPMorgan Chase's (JPM) (rating: A-, narrow moat) 2.35% due in January 2019 are indicated at +67 basis points, which we consider roughly fair. We see better value in Goldman Sachs Group's (GS) (rating: BBB+, narrow moat) 2.625% due in January 2019, which are indicated at +100 basis points, which we consider attractive relative to a fair value of +85. Our equal fair value estimates between BAC and higher-rated GS is due primarily to BAC's deposit funding and broader business model than Goldman Sachs'.
However, in the 10-year area, Bank of America's 4.125% due in 2024 are indicated at 125 basis points to the nearest Treasury, which we consider unattractive relative to fair value of +135 basis points. Citigroup's 3.875% due in 2023 are indicated at +126 basis points, which we consider fair. In this area, Goldman Sachs' 4% due in 2024 are indicated at +135 basis points, which we consider fair.
Assuming a 20-basis-point spread differential from 10- to 30-years, BAC's existing 5.0% due 2044, indicated at 120 basis points to the nearest Treasury, appear expensive relative to fair value of +155. However, since this phenomenon of minimal spread between 10- and 30-year bonds is prevalent for global banks, within the 30-year peer cohort, the new issue notes would be near fair value at +135 basis points. Citigroup's 4.95% due in 2043 are indicated at 125 basis points to the nearest Treasury, which we consider fair within the group. Goldman Sachs' 6.25% notes due in 2041 are indicated at +149 basis points, which we consider attractive relative to the group's fair value of +135.
Bank of America posted solid results in 2013 with net income of $11.4 billion more than double the level in 2012. The bank was successful increasing net interest income--up nearly 4% on the year--while decreasing noninterest expense by a similar amount. Bank of America's balance sheet is now in fairly good shape, with a Basel III Tier 1 common ratio of 9.96%. We expect the company to exceed 10% in early 2014. Net charge-offs have decreased to 0.9% in 2013, down 80 basis points from the prior year. Nonperforming loans have also shown improvement, ending the year at 1.93% of loans compared with 2.62% in the year earlier, while loan-loss coverage has decreased slightly but still remains at healthy levels near 100%. Although these and other measures are clearly moving in the right direction, the bank has room for further improvement.
Canadian Natural Resources to Sell 2- and 10-Year Notes; 10-Year Fair Value at +120 (March 26)
Exploration and production company Canadian Natural Resources (CNQ) (rating: BBB+, narrow moat) announced that it is issuing 2-year floating-rate notes and 10-year fixed-rate notes. Initial price talk is in the +130 area for the 10-year. As we wrote in our Potential New Issue Supply publication, we expected CNQ to issue new debt to help fund its CAD 3.1 billion acquisition of Devon Energy's conventional Canadian assets, which is expected to close April 1. When the Devon deal was announced in February, CNQ also announced a new CAD 1.0 billion term loan facility. Pro forma for the acquisition, we estimate last-12-months leverage at 1.5 times compared with approximately 1.2 times before the deal. The ratio of debt/proved reserves climbs to $0.41 per thousand cubic feet equivalent from $0.31 per mcfe. Based on our favorable view of the acquisition, the minimal deterioration in credit metrics, our projections for strong free cash flow generation in future years, and management's intent to pay down debt with cash flow, we are maintaining our BBB+ issuer credit rating.
Before today's announcement, CNQ's outstanding 3.45% notes due 2021 traded at 93 basis points over the nearest Treasury. We maintain a market weight recommendation on CNQ and view its outstanding issues as fairly valued. Noble Energy (NBL) (rating: BBB+, narrow moat) is a fair comparable for CNQ. Noble's 4.15% notes due 2021 recently traded at 94 basis points over the nearest Treasury, which we view as fair. Based on our outlook for CNQ, relative trading levels, and three additional years to maturity, we peg fair value at +120 for the new 10-year notes.
Kindred Issuing New Unsecured Notes; Fair Value Around 6.375% (March 26)
Kindred Healthcare (KND) (rating: B-, no moat) is in the private placement market issuing $500 million in new senior unsecured 8-year notes, which are noncallable for 3 years. The proceeds from this offering will probably be used to refinance its 8.25% senior unsecured notes due in 2019, which have $550 million in principal outstanding and are callable June 1 at a price of 106.188. Given Kindred's relatively high ongoing interest commitments and low interest rates available in the debt market, it is not surprising that management aims to refinance its senior unsecured notes. Beyond this refinancing, management has stated intentions to refinance its secured obligations, which consisted of $1.0 billion in credit facility borrowings at the end of December. We plan to remove Kindred from our Potential New Issue Supply list once its refinancing activities are complete.
We view fair value on Kindred's new senior unsecured notes around a yield of 6.375%, which would value the notes similarly to those from Tenet Healthcare (THC) (rating: B, no moat), despite their one-notch credit rating difference. For example, Tenet's 8.125% senior unsecured notes due in 2022 are indicated at a yield to worst of 6.41%. Because of its higher rating and deleveraging goals, we maintain an overweight recommendation on Tenet. We think fair value on Tenet's notes should be closer to Select Medical Holdings' (SEM) (rating: B, no moat) 6.375% senior unsecured notes due in 2021, which are indicated at a yield to worst of 6.03%. We believe all of the above health-care service providers represent better values than HCA Holdings (HCA) (rating: B+, no moat); HCA's 6.25% senior unsecured notes due in 2021 are indicated at a yield to worst of 5.12%.
Kindred's high financial leverage--which includes significant secured debt, unsecured debt, and operating leases--limits its financial flexibility. At the end of December, Kindred owed $1.6 billion in debt and held only $40 million in cash on its balance sheet. Its capital structure included $1.0 billion of secured debt and $550 million of senior unsecured notes, or gross debt/EBITDA around 5.5 times at the end of 2013. On top of its secured and unsecured debt, Kindred operates with significant lease obligations, which add more than a turn of leverage to the mix on an adjusted debt/EBITDAR basis. Kindred's leverage appears similar to Tenet's acquisition-inflated leverage; at the end of 2013, Tenet's debt/EBITDA stood at 6.1 times and its adjusted debt/EBITDAR stood at 6.5 times, making them good health-care service comparables currently, in our opinion.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.