Credit Market Weakness Exacerbated by Gross' Departure From PIMCO
Widening high-yield spreads will start to attract investors.
It was hard to put a finger on any one factor that caused the weakness in the capital markets last week, but the "risk off" mentality certainly predominated. Some pointed to weakness in German industrial metrics, which resurfaced concerns that Europe is on the precipice of entering another recession, and others pointed to Chinese economic indicators, which indicated that economic growth in China and other emerging-market economies is dwindling. In the corporate bond market, a few traders reported that many mutual fund managers indicated that their cash levels have sunk to very low levels as cash has been used over the past six weeks to absorb the near-record-breaking amount of new issues. In addition to the low levels of cash at the fixed-income funds, one source in the equity market said the volume of initial public offerings in the equity market, including the record-breaking Alibaba (BABA) (not rated, wide moat), had sopped up all of the cash in the equity funds as well and led to selling pressure in the equity markets. On top of the low levels of cash, the credit spreads of new issue bonds have been priced with very little or no concession to outstanding debt and have not performed very well in the secondary market, curbing investor enthusiasm.
While all of these factors played a part in last week's weakness, it was the surprise departure of Bill Gross from PIMCO that exacerbated the sell-off in the bond market Friday. Traders looked to quickly sell down positions, as his departure is thought to potentially cause significant dislocations in the fixed-income markets. If a considerable amount of investors decide to pull their funds from PIMCO, those funds will need to sell bonds to cover redemptions. With low levels of cash and dealers keeping their inventory levels to a bare minimum, even if investors reallocate into fixed-income funds with other mutual fund companies, it will take some time for that amount of cash to be put back to work.
All is not lost, though; several traders reported that many institutional investors expect inflows into the corporate bond market at the beginning of October, probably as a result of rebalancing and asset reallocation after quarter-end. In addition, the amount of demand from Europe for U.S. dollar-denominated debt has steadily risen with the weakness of the euro. Bonds issued under Reg S (regulatory exclusion for bonds sold directly to overseas buyers) were in high demand and in some cases traded through the same companies' registered bonds. These factors will help limit any meaningful further spread widening in the near term.
Widening High-Yield Spreads Will Start to Attract Investors
In the corporate bond market, there is a growing perception that corporate credit spreads are priced to perfection and that any negative catalyst could cause credit spreads to widen out significantly. In the investment-grade space, the average spread of the Morningstar Corporate Bond Index widened out 5 basis points over the course of last week. In the investment-grade marketplace, on a rating-adjusted basis, credit spreads are still not that much higher than their all-time lows in February 2007. At +115 basis points over Treasuries, the average credit spread of the Morningstar Corporate Bond Index is about 40 basis points tighter than the median level and 60 basis points tighter than the average level over the past 15 years. Even after stripping out the impact of the 2008-09 credit crisis, the current level is still very tight compared with historical averages.
Even though retail fund flows returned to positive territory in the high-yield market, it was not enough to stanch the bleeding. One high-yield trader went so far as to say that the market was "destroyed" last week. The average spread of the Bank of America Merrill Lynch High Yield Master II Index widened 43 basis points to +440 from +397, its widest level since November 2013. Considering the index has widened more than 100 bp from where it bottomed out at +335 in June, we suspect that investors will begin to return to the high-yield market. Although the high-yield spread is still significantly tighter than the long-term average spread of the index of +550 (excluding the greatest impact of the 2008-09 credit crisis), we expect that moderate economic growth for the remainder of 2014 and 2015 will help keep default rates lower than the historical average.
Upgrades Outpace Downgrades in a Busy Week for Rating Actions
Morningstar credit analysts had a busy week last week, as we upgraded our ratings on four companies, affirmed our ratings on two companies, downgraded one issuer, initiated credit coverage on one firm, and placed our ratings for three issuers under review.
We upgraded our credit rating on USG (rating: BB-, narrow moat) one notch to BB- after updating our financial forecast. As USG continues to execute on its emergence from the sharp cyclical downturn, we expect it to become solidly free cash flow positive in 2014 for the first time since it emerged from bankruptcy in 2006. While debt levels have remained flat at $2.3 billion over the past few years, we expect progress on meaningful debt paydown to begin in 2015. Masco's (MAS) (rating: BBB-, no moat) rating was lifted by one notch to BBB- based on our updated forecasts, which include continued deleveraging. Masco has continued to produce solid improvement in EBITDA in 2014 on improvement in its core residential repair and remodel markets along with improved execution in its struggling installation and cabinet businesses. In the building material sector, we initiated credit coverage of Mohawk Industries MHK (rating: BBB, no moat) with a rating of BBB. Our credit rating reflects the firm's leading position and diversification in the flooring industry offset by modest leverage and healthy competition. Rounding out our upgrades, in the banking sector, we upgraded our credit ratings on Bank of Montreal (BMO) (rating: A+, narrow moat) to A+ from A and on Lloyds Banking Group (LYG) (rating: BBB+, narrow moat) to BBB+ from BBB. The upgrades reflect improved operating performance, solid credit quality, and increased regulatory capital levels.
We downgraded our credit rating on Amphenol (APH) (rating: A-, narrow moat) to A- from A. The combination of a share-repurchase program and acquisitions has created a cash flow gap that the company has been funding via its credit facilities and term debt. As a result, leverage has increased materially in recent years.
We affirmed our BBB credit rating for Eastman Chemical (EMN) (rating: BBB, no moat). We had placed Eastman's credit rating under review after the company's announced $2.8 billion acquisition of specialty chemical company Taminco, which is expected to increase total leverage to around 3 times from the current 2.2 times. While the new debt will weaken the company's Cash Flow Cushion, we do not believe it is sufficient to result in a downgrade at this time. We also affirmed our BBB+ rating on TE Connectivity (TEL) (rating: BBB+, no moat). While leverage is likely to rise in the near term as the company absorbs acquisitions, we believe TE's long-term risk profile remains consistent with our current rating.
We placed Merck KGaA's (MKGAY) (rating: A/UR-, narrow moat) credit rating under review with negative implications after the firm announced a plan to acquire Sigma-Aldrich (not rated, narrow moat) for $17 billion in cash by mid-2015. Merck will fund most of this transaction with debt borrowings, which may push net leverage up by about 3 turns to the mid-3s on a pro forma basis initially after the transaction. We also placed our credit ratings for Vale (VALE) (rating: BBB+/UR-, narrow moat) and Anglo American (AAL) (rating: BBB/UR-, no moat) under review with negative implications following a change in our forecast of seaborne iron ore prices. Diminished Chinese demand expectations account for much of the change to our outlook. We now expect real prices to average $70 per ton in 2018, the terminal year of our valuation model, down from a prior forecast of $90.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.